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Liquidity and Credit Default Swap SpreadsDragon Yongjun TangUniversity of Hong Kong - School of Economics and Finance Hong YanUniversity 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 Abstract: 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, E44 working papers seriesDate posted: March 3, 2008 ; Last revised: January 22, 2009Suggested CitationContact Information
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