Does Credit Risk Impact Liquidity Risk? Evidence from Credit Default Swap Markets

International Journal of Applied Economics, 12(2), September 2015, 1-46

46 Pages Posted: 21 Apr 2014 Last revised: 12 Nov 2015

See all articles by Markus Hertrich

Markus Hertrich

University of Basel - Center for Economic Science (WWZ) - Department of Finance; Deutsche Bundesbank

Date Written: April 20, 2014

Abstract

During the recent financial crisis that erupted in mid-2007, credit default swap spreads increased by several hundred basis points, accompanied by a liquidity shortage in the U.S. financial sector. This period has both evidenced the importance that liquidity has for investors and underlined the need to understand the linkages between credit markets and liquidity. This paper sheds light on the dynamic interactions between credit and liquidity risk in the credit default swap market. Contrary to the common belief that illiquidity leads to a credit risk deterioration in financial markets, it is found that in a sample of German and Swiss companies, credit risk is more likely to be weakly endogenous for liquidity risk than vice versa. The results suggest that a negative credit shock typically leads to a subsequent liquidity shortage in the credit default swap market, in the spirit of, for instance, the liquidity spiral posited by Brunnermaier (2009), and extends our knowledge about how credit markets work, as it helps to explain the amplification mechanisms that severely aggravated the recent crisis and also indicates which macro-prudential policies would be suitable for preventing a similar financial crisis in the future.

Keywords: financial crisis, credit default swap, credit risk, liquidity risk, endogeneity, macroprudential policy

JEL Classification: E37, E61, G14, G32, G38

Suggested Citation

Hertrich, Markus, Does Credit Risk Impact Liquidity Risk? Evidence from Credit Default Swap Markets (April 20, 2014). International Journal of Applied Economics, 12(2), September 2015, 1-46. Available at SSRN: https://ssrn.com/abstract=2426979 or http://dx.doi.org/10.2139/ssrn.2426979

Markus Hertrich (Contact Author)

University of Basel - Center for Economic Science (WWZ) - Department of Finance ( email )

Peter Merian-Weg 6
Basel, 4052
Switzerland

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

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