Liquidity and Credit Default Swap Spreads

44 Pages Posted: 3 Mar 2008 Last revised: 22 Jan 2009

See all articles by Dragon Yongjun Tang

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics

Hong Yan

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Multiple version iconThere are 2 versions of this paper

Date Written: September 4, 2007

Abstract

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

Tang, Dragon Yongjun and Yan, Hong, Liquidity and Credit Default Swap Spreads (September 4, 2007). AFA 2007 Chicago Meetings Paper; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=891263 or http://dx.doi.org/10.2139/ssrn.891263

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics ( email )

KKL 1004
Pokfulam Road
Pokfulam
Hong Kong
(852)22194321 (Phone)

Hong Yan (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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