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Liquidity Risk in Credit Default Swap Markets

Author

Listed:
  • Benjamin Junge

    (Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne - Ecole Polytechnique Fédérale de Lausanne)

  • Anders B. Trolle

    (HEC Paris - Finance Department)

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.

Suggested Citation

  • Benjamin Junge & Anders B. Trolle, 2013. "Liquidity Risk in Credit Default Swap Markets," Swiss Finance Institute Research Paper Series 13-65, Swiss Finance Institute, revised Aug 2015.
    • Handle: RePEc:chf:rpseri:rp1365
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    File URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2371374
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    Citations

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    Cited by:

    1. Emil Siriwardane, 2014. "Using proprietary credit default swap (CDS) data from 2010 to 2014, I show that capital fluctuations for sellers of CDS protection are an important determinant of CDS spread movements. I first establi," Working Papers 14-10, Office of Financial Research, US Department of the Treasury, revised 12 Feb 2015.
    2. Gao, Feng & Li, Yubin & Wang, Xinjie & Zhong, Zhaodong (Ken), 2021. "Corporate social responsibility and the term structure of CDS spreads," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 74(C).
    3. Gündüz, Yalin, 2020. "The market impact of systemic risk capital surcharges," Discussion Papers 09/2020, Deutsche Bundesbank.
    4. Irresberger, Felix & Weiß, Gregor N.F. & Gabrysch, Janet & Gabrysch, Sandra, 2018. "Liquidity tail risk and credit default swap spreads," European Journal of Operational Research, Elsevier, vol. 269(3), pages 1137-1153.
    5. Wang, Xinjie & (Ken) Zhong, Zhaodong, 2022. "Post-crisis regulations, market making, and liquidity in over-the-counter markets," Journal of Banking & Finance, Elsevier, vol. 134(C).
    6. Matteo Michielon & Asma Khedher & Peter Spreij, 2021. "From bid-ask credit default swap quotes to risk-neutral default probabilities using distorted expectations," Papers 2108.06578, arXiv.org.
    7. Boyarchenko, Nina & Kovner, Anna & Shachar, Or, 2020. "It’s what you say and what you buy: A holistic evaluation of the Corporate Credit Facilities," CEPR Discussion Papers 15432, C.E.P.R. Discussion Papers.
    8. Akari, Mohamed-Ali & Ben-Abdallah, Ramzi & Breton, Michèle & Dionne, Georges, 2021. "The impact of central clearing on the market for single-name credit default swaps," The North American Journal of Economics and Finance, Elsevier, vol. 56(C).
    9. Peter Christoffersen & Kris Jacobs & Xisong Jin & Hugues Langlois, 2018. "Dynamic Dependence and Diversification in Corporate Credit [Asymmetric correlations of equity portfolios]," Review of Finance, European Finance Association, vol. 22(2), pages 521-560.
    10. Feixue Gong & Gregory Phelan, 2016. "Debt Collateralization, Structured Finance, and the CDS Basis," Department of Economics Working Papers 2016-06, Department of Economics, Williams College, revised Aug 2017.
    11. Pierre Collin‐Dufresne & Benjamin Junge & Anders B. Trolle, 2020. "Market Structure and Transaction Costs of Index CDSs," Journal of Finance, American Finance Association, vol. 75(5), pages 2719-2763, October.
    12. Boyarchenko, Nina & Kovner, Anna & Shachar, Or, 2022. "It’s what you say and what you buy: A holistic evaluation of the corporate credit facilities," Journal of Financial Economics, Elsevier, vol. 144(3), pages 695-731.
    13. Yuriy Kitsul & Marcelo Ochoa, 2016. "Funding Liquidity Risk and the Cross-section of MBS Returns," Finance and Economics Discussion Series 2016-052, Board of Governors of the Federal Reserve System (U.S.).
    14. Feixue Gong & Gregory Phelan, 2023. "Collateral constraints, tranching, and price bases," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(2), pages 317-340, February.
    15. Gong Feixue & Gregory Phelan, 2017. "Debt Collateralization, Structured Finance, and the CDS Basis," Department of Economics Working Papers 2017-06, Department of Economics, Williams College.
    16. Benjamin Hippert & André Uhde & Sascha Tobias Wengerek, 2019. "Portfolio benefits of adding corporate credit default swap indices: evidence from North America and Europe," Review of Derivatives Research, Springer, vol. 22(2), pages 203-259, July.
    17. Christian Koziol & Philipp Koziol & Thomas Schön, 2015. "Do correlated defaults matter for CDS premia? An empirical analysis," Review of Derivatives Research, Springer, vol. 18(3), pages 191-224, October.
    18. Javadi, Siamak & Mollagholamali, Mohsen, 2018. "Debt market illiquidity and correlated default risk," Finance Research Letters, Elsevier, vol. 26(C), pages 266-273.
    19. Antje Berndt & Rohan Douglas & Darrell Duffie & Mark Ferguson, 2018. "Corporate Credit Risk Premia [Fallen angels and price pressure]," Review of Finance, European Finance Association, vol. 22(2), pages 419-454.

    More about this item

    Keywords

    CDS; Credit Index; Index Arbitrage; Liquidity Risk;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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