The estimation of default probabilities with liquidity by Markov chain

The effection of liquidity on the financial risk is becoming more and more important. Ignoring it the risk analysis would be in failure. This paper provides a default-risky debt valuation model, which assumes that market liquidity modelled by the intensity of default is driven by a continuous-time Markov chain. The model accounts for default probability with liquidity risk calibrated. A semimartingale representation of a liquid defaultable debt price is obtained. The illiquidity is modelled as exogenously specified stochastic reduction in the price of the debt, which adds more risks for the investors.