Credit Default Swap and Liquidity

Abstract Using data from the credit default swap (CDS), corporate bond, and equity markets, we construct several measures of liquidity and examine the spill-over of liquidity shocks across these markets. Based on the principal component analysis of multiple liquidity measures, we show that there is a dominant first principal component in each of the markets. However, the linkage of liquidity shocks varies between dierent,markets. In particular, there is a common component between the equity and both CDS and bond markets, but not between the CDS and bond market. Moreover, the vector autoregression results show that while there is spill-over of liquidity shocks between equity and CDS markets, surprisingly there is no clear spill-over of liquidity shocks between equity and bond markets. There appears to be a time lag of liquidity spill-over from the CDS to both bond and equity markets. Finally, we find no evidence of liquidity spill-over from bond to CDS market. Key Words: Liquidity sh...

SSRN Electronic Journal

This paper explores the relationship between funding liquidity and credit default swap (CDS) spreads, evidencing the effects of the regulatory changes brought about by the introduction of the CDS Small Bang reforms for CDS contracts on European reference entities in June 2009. Using panel estimations, this study provides evidence that a tightening of funding liquidity increases CDS spreads, an effect which is three times larger in magnitude for high-CDS entities compared to low-CDS firms. This relationship increases in magnitude and significance after the implementation of the CDS Small Bang reforms which introduced fixed coupons for trading CDSs, leading to the exchange of upfront fees between CDS contract parties.

2020

We analyze whether the CDS market released any abnormal signals that could have been discerned prior to the 1988 subprime chaos that brought about the global financial crisis. In particular, an examination of the conformity of this market with the standard day-today market factors is our aim. Our results indicate that the CDS market was linked to a number of other financial entities, that it affected and was affected by a select major financial variables, and that it was functioning normally in the sense of being similar to other financial markets. However, while the market was riding on the interplay of its forces, very regrettably the underlying trust and assumptions were never questioned.

2016

der Reyngold, who worked with us on the methodology of the Fitch Solutions liquidity project, contributing to our insight in this challenging field. This work expresses the opinion of its authors and is in no way representing the opinion of the institutions the authors work for

Journal of Financial and Quantitative Analysis, 2011

The recent credit crisis has highlighted the importance of market liquidity and its interaction with the price of credit risk. We investigate this interaction by relating the liquidity of corporate bonds to the basis between the credit default swap (CDS) spread of the issuer and the par-equivalent bond yield spread. The liquidity of a bond is measured using a recently developed measure called latent liquidity, which is defined as the weighted average turnover of funds holding the bond, where the weights are their fractional holdings of the bond. We find that bonds with higher latent liquidity are more expensive relative to their CDS contracts after controlling for other realized measures of liquidity. Analysis of interaction effects shows that highly illiquid bonds of firms with a greater degree of uncertainty are also expensive, consistent with limits to arbitrage between CDS and bond markets, due to the higher costs of “shorting” illiquid bonds. Additionally, we document the posit...

SSRN Electronic Journal, 2000

This paper investigates the role of credit and liquidity factors in explaining corporate CDS price changes during normal and crisis periods. We find that liquidity risk is more important than credit risk regardless of market conditions. Moreover, in the period prior to the recent "Great Recession" credit risk plays no role in explaining CDS price changes. The dominance of liquidity effects casts serious doubts on the relevance of CDS price changes as an indicator of default risk dynamics.

We use the information in credit default swaps to obtain direct measures of the size of the default and nondefault components in corporate spreads. We find that the majority of the corporate spread is due to default risk. This result holds for all rating categories and is robust to the definition of the riskless curve. We also find that the nondefault component is time varying and strongly related to measures of bond-specific illiquidity as well as to macroeconomic measures of bond market liquidity.

SSRN Electronic Journal, 2019

Using regulatory data on CDS holdings and corporate bond transactions, I provide evidence for a liquidity spillover effect from CDS to bond markets. Bond trading volumes are larger for investors with CDS positions written on the debt issuer, in particular around rating downgrades. I use a quasi-natural experiment to validate these findings. I also provide causal evidence that CDS mark-to-market losses lead to fire sales in the bond market. I instrument for the prevalence of mark-to-market losses with the fraction of non-centrally cleared CDS contracts of an individual counterparty. The monthly corporate bond sell volumes of investors exposed to large mark-to-market losses are three times higher than those of unexposed counterparties. Returns decrease by more than 100 bps for bonds sold by exposed investors, compared to same-issuer bonds sold by unexposed investors. My findings underline the risk of a liquidity spiral in the credit market.

2013

The global crisis of 2007-2008 is the most severe crisis since the Great Depression in the financial markets. Starting with the subprime defaults in the United States, it quickly spills over into other markets leading to the collapses of many financial institutions, bail-outs of banks worldwide and downturns in asset prices. The aim of this thesis is to investigate the repercussions of this crisis on CDS and interbank market and provide empirical evidence on the changes in the pricing of CDS contracts and interbank deposits. Chapter 2 discusses the determinants of CDS spread changes on European contracts. The most remarkable finding of the study is that the relation between credit spreads and their determinants is regime dependant and depends on the sector of economic activity. Before the crisis the underlying credit risk in the overall CDS market is sufficient to explain credit risk. During the crisis investors have a differing view on the risk of financial and non--financial contr...

This article re-examines the determinants of credit default swaps (CDS) spreads in the United States, Europe and Asia-Pacific markets with new data set using linear regressions. These determinants are categorized into two groups: firm-level and macroeconomic variables. We also include two non-traditional moment risk variables in the analysis as we suspect that these measures may capture the effects of possible extreme downside risk, or extreme negative scenarios, in the underlying credit valuation process. Our findings from the United States and abroad confirm the existing evidence on the significant relationship between theoretical determinants of default risk and actual market pricing of CDS. In addition, we provide additional evidence on the importance of the interaction between macroeconomic and firm-specific variables, which is common throughout the world.

Journal of Financial Economics, 2012

We investigate whether liquidity is an important price factor in the US corporate bond market. In particular, we focus on whether liquidity effects are more pronounced in periods of financial crises, especially for bonds with high credit risk, using a unique data set covering more than 20,000 bonds, between October 2004 and December 2008. We employ a wide range of liquidity measures and find that liquidity effects account for approximately 14% of the explained market-wide corporate yield spread changes. We conclude that the economic impact of the liquidity measures is significantly larger in periods of crisis, and for speculative grade bonds.

Available at SSRN 1268367, 2008

The purpose of this paper is to use insights from the academic literature on crises to understand the role of liquidity in the current crisis. We focus on four of the crucial features of the crisis that we argue are related to liquidity provision. The first is the fall of the prices of AAA-rated tranches of securitized products below fundamental values. The second is the effect of the crisis on the interbank markets for term funding and on collateralized money markets. The third is fear of contagion should a major institution fail. Finally, we consider the effects on the real economy.

2010

Essay 1 tests the ability of a commercial structural credit default swap pricing model to predict market spreads. Consistent with several previous studies testing other models, we find our model unable to price credit risk precisely and observe an illiquidity premium reflecting a credit risk component which should be incorporated into future pricing models. We also identify macroeconomic and stock market factors that help explain movements in CDS spreads beyond the levels suggested by the model. Essay 2 looks at bid and ask spreads to find evidence of quote shading where dealers manipulate their quotes in order to attract sell orders. This is something not yet studied in CDS literature and we draw on studies on the foreign exchange markets for theoretical support. We find that dealers are more likely to indulge in quote shading when firm risk increases but not close to weekends or holidays. We also look at price discovery with and without quote shading but our results are inconclusive. Using the put-call ratio as a risk level indicator, we find that price discovery in the CDS market decreases as firm risk increases. Essay 3 looks at the quality of the CDS market in the backdrop of the recent financial crisis. Previous studies have found that CDS markets lead price discovery only in the case of high risk firms and this paper tests if price discovery dynamics have shifted in favour of the CDS market since overall firm risk levels have increased. Using Grangercausality tests, we compare stock and CDS markets before and since the crisis and finds that despite an overall increase in risk levels, the stock market continues to lead the CDS market in all risk categories. We also test the CDS market for mis-reaction using Variance Ratios and find that while there was evidence of over-reaction before the crisis, CDS market is under-reacting since the crisis.

Canadian Journal of Economics Revue Canadienne D Economique, 2013

Georges Dionne thanks École Polytechnique in France for its hospitality during the writing of different versions of this article. Both authors thank Albert Lee Chun, Mohamed Jabir, and Claire Boisvert for their generous help. Comments from Linda Allen, David Green and an anonymous referee were very useful to improve the previous versions.

Recent research has shown that default risk accounts for only a part of the total yield spread onrisky corporate bonds relative to their risk-less benchmarks. One candidate for the unexplained portionof the spread is a premium for liquidity. We investigate this possibility by relating the liquidity ofcorporate bonds to the basis between the credit default swap (CDS) price of the issuer and the parequivalentcorporate bond yield spread. The liquidity of a bond is measured using a recently developedmeasure called latent liquidity, which is defined as the weighted average turnover of funds holding thebond, where the weights are their fractional holdings of the bond. We find that bonds with higherlatent liquidity are more expensive relative to their CDS contracts, after controlling for other realizedmeasures of liquidity. However highly illiquid bonds with high default risk are also expensive, consistentwith limits to arbitrage between CDS and bond markets, due to the higher costs of â¬S...