Liquidity, credit quality, and the relation between volatility and trading activity: Evidence from the corporate bond market

This paper investigates the roles of illiquidity and credit risk in determining the relations between price volatility of a bond and its trading frequency and trade size based on a large transaction dataset from October 2004 to June 2012. We find a positive relation between volatility and trading frequency and a negative relation between volatility and trade size. Consistent with the prediction of the search-based theory, the relations are much stronger for illiquid and risky bonds. Furthermore, both liquidity and credit risk become more important in times of stress and their effects are reinforcing. Results strongly suggest that search frictions and credit risk are important factors driving the relation between volatility and trading activity in the corporate bond market.