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Implied liquidity risk premium in the term structure of sovereign credit default swap and bond spreads

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  • Saad Badaoui
  • Lara Cathcart
  • Lina El-Jahel

Abstract

In this study, we focus on the dynamic properties of the risk-neutral liquidity risk premium specific to the sovereign credit default swap (CDS) and bond markets. We show that liquidity risk has a non-trivial role and participates directly to the variation over time of the term structure of sovereign CDS and bond spreads for both the pre- and crisis periods. Secondly, our results indicate that the time-varying bond and CDS liquidity risk premium move in opposite directions which imply that when bond liquidity risk is high, CDS liquidity risk is low (and vice versa), which may in turn be consistent with the substitution effect between CDS and bond markets. Finally, our Granger causality analysis reveals that, although the magnitude of bond and CDS liquidity risk is substantially different, there is a strong liquidity flow between the CDS and the bond markets, however, no market seems to consistently lead the other.

Suggested Citation

  • Saad Badaoui & Lara Cathcart & Lina El-Jahel, 2016. "Implied liquidity risk premium in the term structure of sovereign credit default swap and bond spreads," The European Journal of Finance, Taylor & Francis Journals, vol. 22(10), pages 825-853, August.
    • Handle: RePEc:taf:eurjfi:v:22:y:2016:i:10:p:825-853
    DOI: 10.1080/1351847X.2014.996297
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    Cited by:

    1. Tsuruta, Masaru, 2020. "Decomposing the term structures of local currency sovereign bond yields and sovereign credit default swap spreads," The North American Journal of Economics and Finance, Elsevier, vol. 51(C).

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