Liquidity And The Pricing Of Credit Default Swaps

Liquidity risk plays a crucial role in the exacerbation and contagion of globalfinancial crisis and sovereign debt crisis. During the crisis, many experts expressedconcern that manipulation of the CDS market by speculative investors was playing acrucial role in exacerbating the liquidity dry up in the market for sovereign andcoporate debt. This paper focuses on liquidity factors and their impacts on CDSpricing. We analyse the contagion mechanism of liquidity risk from micro perspective.Finaly, policy implications of future innovation and risk management for creditderivatives are proposed.Base on the famous liquidity-adjusted CAPM model proposed by Acharya andPedersen(2005), we develop an equilibrium pricing theory incorporating liquidityfactors for derivative instruments within the frameworks of Non zero-sum game andzero-sum game respectively. The zero-sum game circumstance of such equilibriumpricing theory is then applied to evaluation of CDS. We successful decompose thecredit spread of CDS into three major components: credit risk, firm-specificidiosyncratic liquidity and industry-wide systemic liquidity. In the following empiricalstudy, we explore the credit and liquidity determinants of CDS prices and investigatehow their role changed as a result of the financial and sovereign debt crisis. Ourempirical results show that:⑴liquidity effects rather than credit risk dominate CDSprice variations which has an implication that severity and contagion of the crisis wasmainly due to liquidity factors.⑵liquidity variables are the only ones that arestatistically significant in the pre-crisis period which suggest that default risk wasusually under-priced during the pre-crisis credit bubble.⑶Informed trading has anremarkable impact on CDS prices.⑷Trade impact increases with higher bid-askspread and it decreases for high credit quality reference entities.⑸illiquidity stemsfrom asymmetric information among agents is a major contributing factor to riskcontagion and the reverse selection problem of such asymmetric information leads tohigh volatility of CDS price during crisis.