Corporate Credit Default Swap Liquidity and Its Implicationsfor Corporate Bond Spreads

Abstract

In a credit default swap (CDS) trade, a credit protection buyer acquires credit protection from the counterparty by paying a premium. The CDS premium has been viewed as a clean representation of the price of credit risk. As a result, in the past few years, researchers have used data on CDS trades where the reference entity is a corporation to determine the liquidity component of corporate bond spreads. Using a transaction dataset, the authors discover very large bid–ask spreads in CDS quotes. With a two-factor model, they show that such large bid–ask spreads can profoundly affect the estimation of credit risk, which in turn has a significant effect on the estimation of the liquidity spread for corporate bonds. Contrary to the literature, the authors show that although the bond and CDS markets appear to have two different values for the credit spread, once liquidity is accounted for they no longer find such a difference. TOPICS:Credit default swaps, fixed-income portfolio management, factor-based models, simulations

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