Liquidity and Credit Default Swap Spreads

TLDR

The study investigates how liquidity influences pricing in the credit default swap market. Liquidity proxies were built to represent adverse selection, search frictions, and inventory costs in the CDS market. Liquidity has a significant premium on CDS spreads comparable to Treasury and corporate bonds, with cross‑sectional variation revealing search‑friction and adverse‑selection dynamics, and liquidity risk being priced beyond mere liquidity levels.

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.