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

Markus Hertrich

MPRA Paper from University Library of Munich, Germany

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 (search for similar items in EconPapers)
JEL-codes: E37 E61 G14 G32 G38 (search for similar items in EconPapers)
Date: 2015-09
New Economics Papers: this item is included in nep-ban, nep-cfn, nep-mac and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Published in International Journal of Applied Economics 12.2(2015): pp. 1-46

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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:67837

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