Abstract: Recent empirical studies have shown that liquidity risk and its correlation with default risk are important factors to explain defaultable bond yields. However, the models incorporatoing liquidity risk for defaultable bond pricing are either too simple to deal with various risk correlation or too complex to be applied in practice. The common property of liquidity risk and default risk is that they are both claim-termination event driven risk. This faciliates the work in extending traditional default risk model for defaultable bond to incorporate liquidity risk and risk correlation. The pricing model based on claim-termination has three main advantages over traditional models: easy to implement in practice, allowing time-varying liquidity risk, and easy to deal with various correlation between liquidity risk and default risk including tail dependence.

Key words: pricing of defaultable bond, liquidity risk, claim termination, risk correlation