The Role of Liquidity in the Credit Default Swap Market: A Comparative Analysis of the Recent Crisis and Post-Crisis Period in the U.S.

Marn Rolle & Philippe Bourghardt

Student thesis: Master thesis

Abstract

The recent financial crisis is characterised by liquidity dry-ups, which enhanced the disruption of financial markets. We analyse the role of liquidity in the U.S. CDS market during 2008-2012, distinguishing explicitly between a crisis (2008-2009) and post-crisis (2010-2012) period. First, we investigate whether illiquidity is priced in a CDS contract and find that the protection seller earns an illiquidity premium, controlling for credit risk. This compensation is not affected by the economic regime. In addition, we study the determinants of illiquidity related to a CDS contract and find that a market maker’s inventory costs are the main driver. Furthermore, asymmetric information and a market maker’s funding constraints affect CDS illiquidity. Again, these findings are not affected by the economic regime. Lastly, we research whether the risk a CDS contract becomes illiquid in the future (i.e. liquidity risk) is priced, controlling for the current level of illiquidity and credit risk. The analysis provides evidence for a liquidity risk premium earned by the protection seller during the crisis, whereas such a premium is not observed postcrisis. The differential impact of liquidity risk on the pricing of CDS contracts can be attributed to the relative ease of trading in tranquil versus turbulent time periods.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2016
Number of pages113