On the compensation for illiquidity in sovereign credit markets

Juan Angel Lafuente and Pedro Serrano

Journal of Multinational Financial Management, 2015, vol. 30, issue C, 83-100

Abstract: This article analyzes the role of liquidity in the sovereign credit default swap (CDS) market. We employ a continuous-time specification to incorporate illiquidity as an additional pricing factor of default swap contracts for the most developed economies. The illiquidity discount process is identified as compensation to investors for the risk of unwinding their positions when trading in the less liquid part of the curve, and the information about illiquidity is directly extracted from the term structure of sovereign CDS spreads. Our empirical findings reveal that a positive time-varying illiquidity premium is embedded in sovereign default swaps. These risk premia exhibit substantial comovement across countries. Only unidirectional causality from default to liquidity is detected for the overall market.

Keywords: Credit default swap; Illiquidity; Default; Risk premium (search for similar items in EconPapers)
JEL-codes: F30 G12 G13 G32 (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (1)

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Working Paper: On the compensation for illiquidity in sovereign credit markets (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:mulfin:v:30:y:2015:i:c:p:83-100

DOI: 10.1016/j.mulfin.2015.03.003

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