Liquidity Risk in Credit Default Swap Markets

Benjamin Junge and Anders B. Trolle
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Benjamin Junge: Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne
Anders B. Trolle: HEC Paris - Finance Department

No 13-65, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

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 (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 83 pages
Date: 2013-12, Revised 2015-08
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Citations: View citations in EconPapers (24)

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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1365

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