The Illiquidity of CDS Market: Evidence From Index Inclusion
34 Pages Posted: 28 Jun 2013 Last revised: 15 Nov 2014
Date Written: November 6, 2014
Abstract
Is the CDS market liquid? Researchers claim that CDS market is liquid and thus the spreads reflect pure default risk. We investigate this claim. Since it is hard to measure liquidity precisely, we use an event study when a CDS is included into the CDX index. This event changes the liquidity of CDS because the liquidity of CDX will flow through individual CDSs. If the CDS market is liquid, we should observe no change because index inclusion does not change default risk. However, we find significant abnormal spread increase after index inclusion, but the change is not permanent. Contrary to the belief, index inclusion temporarily reduces the liquidity of CDS market due to the spike of demand and dealers' inventory risk. Order imbalance causes price impact as dealers manage their inventory risk. Index exclusion however has no effect on CDS spreads.
Keywords: CDS, liquidity, index inclusion, inventory
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