WorldCom was one of the largest telecommunications companies in the world. Due to accounting fraud, in July 2002 the firm filed for bankruptcy. At the time it was the largest bankruptcy filing in the history of the United States.2
Figure 1.1 shows a time-series graph constructed using WorldCom's stock price movements over the two years prior to its bankruptcy. This graph depicts the assessment of WorldCom's probability of default3—or the risk that it would not pay its debt holders—by the equity markets over a period of time. The probability of default at any one point in time is calculated utilizing a widely used model known as the Merton model.4 The only information being used in the calculations is data from the equity markets—no bond market information is used. Therefore, one can interpret Figure 1.1 as representing the equity market's probability of default assessment of WorldCom.
Figure 1.1 Time series graph of WorldCom's default probability from the equity markets
What we see from Figure 1.1 is that the equity markets start receiving information about trouble at WorldCom beginning in June 2001. From June 2001 to December 2001, the probability of default rises from approximately 2% to about 8%.
Figure 1.2 shows a time-series graph of credit spreads of a corporate bond that was issued by WorldCom in August 1998. A credit spread of a corporate bond is simply the bond's yield less the yield of a corresponding-maturity riskfree (Treasury) bond. Therefore, the credit spread is widely used by markets as an assessment of the likelihood of default of a corporate bond—the larger the credit spread, the higher the likelihood of default. Note that the credit spread of the WorldCom bond over the same time period as that in Figure 1.1 stays relatively flat at 1.8%. This indicates that the corporate bond market is assessing that WorldCom's probability of default has not changed.
Figure 1.2 Time series graph of WorldCom's credit spread
This is a puzzle! How can the equity market and the corporate bond market be arriving at different assessments of WorldCom? The two markets should be getting identical information about WorldCom. So, why does one market seemingly process this information differently and arrive at a different conclusion than the other market?
To answer this question, we have to understand what differences might exist between the equity market and bond market that might explain the divergent expectations. One major difference is the amount of liquidity and liquidity risk in the two markets. The U.S. corporate bond market is orders of magnitude less liquid than the U.S. equity market. As we will see, the difference in liquidity provides the key to explaining this puzzle.