Liquidity Risk in Credit Default Swap Markets

83 Pages Posted: 24 Dec 2013 Last revised: 8 Aug 2015

See all articles by Benjamin Junge

Benjamin Junge

Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne

Anders B. Trolle

Copenhagen Business School - Department of Finance

Date Written: August 7, 2015

Abstract

We show that liquidity risk is priced in the cross section of returns on credit default swaps (CDSs). We measure CDS market illiquidity by aggregating deviations of credit index levels from their no-arbitrage values implied by the index constituents' CDS spreads, and we construct a tradable liquidity factor from returns on index arbitrage strategies. CDS contracts with higher liquidity exposures have higher expected excess returns for sellers of credit protection and trade with wider CDS spreads; on average, liquidity risk accounts for 24% of CDS spreads. Consistent with recent models of intermediary asset pricing, illiquidity and risk premia correlate negatively with proxies for the risk-bearing capacity of CDS market intermediaries.

Keywords: CDS, Credit Index, Index Arbitrage, Liquidity Risk

JEL Classification: G12, G13

Suggested Citation

Junge, Benjamin and Trolle, Anders B., Liquidity Risk in Credit Default Swap Markets (August 7, 2015). Swiss Finance Institute Research Paper No. 13-65, Available at SSRN: https://ssrn.com/abstract=2371374 or http://dx.doi.org/10.2139/ssrn.2371374

Benjamin Junge (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL-Dorigny
Extranef 128
Lausanne, CH-1015
Switzerland

Ecole Polytechnique Fédérale de Lausanne ( email )

Quartier UNIL-Dorigny
Extranef 128
Lausanne, CH-1015
Switzerland

Anders B. Trolle

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

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