How Does Stock Liquidity Affect Default Risk?

Abstract

Firms with greater liquidity experience decreased default risk through firm policy decisions. Specifically, empirical evidence in this paper suggests that bankruptcy risk is mitigated for liquid firms due to less risky investment choices of research and development expenditures and conservative tax avoidance activities. I identify these channels by exploiting exogenous liquidity provisions through decimalization event and S&P index additions. Results from both event studies provide support for the firm policy channels, and are robust to other possible explanations and endogeneity