Liquidity Risk in Credit Default Swap Markets
83 Pages Posted: 24 Dec 2013 Last revised: 8 Aug 2015
Date Written: August 7, 2015
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: Suggested Citation