Liquidity and Credit Default Swap Spreads
Dragon Yongjun Tang
University of Hong Kong - School of Economics and Finance
University of South Carolina; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)
September 4, 2007
AFA 2007 Chicago Meetings Paper
EFA 2008 Athens Meetings Paper
We present an empirical study of the pricing effect of liquidity in the credit default swaps (CDS) market. We construct liquidity proxies to capture various facets of CDS liquidity including adverse selection, search frictions, and inventory costs. We show that the liquidity effect on CDS spreads is significant with an estimated liquidity premium on par with those of Treasury bonds and corporate bonds. Our finding of cross-sectional variations in the liquidity effect highlights the structure of the search-based over-the-counter market and the interplay between search friction and adverse selection in CDS trading. Using liquidity betas and volume respectively to measure liquidity risk, we find supporting evidence for liquidity risk being priced beyond liquidity level in the CDS market.
Number of Pages in PDF File: 44
Keywords: Credit Default Swaps, Credit Spreads, Liquidity, Liquidity Risk
JEL Classification: G12, G13, E43, E44working papers series
Date posted: March 3, 2008 ; Last revised: January 22, 2009
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