Liquidity and Credit Default Swap Spreads
44 Pages Posted: 3 Mar 2008 Last revised: 22 Jan 2009
Date Written: September 4, 2007
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.
Keywords: Credit Default Swaps, Credit Spreads, Liquidity, Liquidity Risk
JEL Classification: G12, G13, E43, E44
Suggested Citation: Suggested Citation