We propose a theoretical framework to study the impact of exogenous illiquidity shock in the secondary corporate debt market on the agency costs (asset substitution) between equity and debt holders. Taking advantage of the closed-form solutions for debt and equity values, we find that liquidity risk increases agency costs, especially for a firm with weak fundamental. Empirically, we use implied asset volatility and earning volatility as proxies for a firm's risk taking and confirm the positive relationship between illiquidity and agency costs. Further, using TRACE dissemination as an exogenous event, we verify the causality between illiquidity and agency cost proxies.
Keywords: Illiquidity; agency costs; asset substitution; asset volatilities
JEL Classification: G12, G13, G32, G33
