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US corporate default swap valuation: the market liquidity hypothesis and autonomous credit risk

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  • Kwamie Dunbar

Abstract

This paper develops a reduced form three-factor model which includes a liquidity proxy of market conditions which is then used to provide implicit prices. The model prices are then compared with observed market prices of credit default swaps to determine if swap rates adequately reflect market risks. The findings of the analysis illustrate the importance of liquidity in the valuation process. Moreover, market liquidity, a measure of investors' willingness to commit resources in the credit default swap (CDS) market, was also found to improve the valuation of investors' autonomous credit risk. Thus a failure to include a liquidity proxy could underestimate the implied autonomous credit risk. Autonomous credit risk is defined as the fractional credit risk which does not vary with changes in market risk and liquidity conditions.

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File URL: http://www.tandfonline.com/doi/abs/10.1080/14697680701397927
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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

Volume (Year): 8 (2008)
Issue (Month): 3 ()
Pages: 321-334

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Handle: RePEc:taf:quantf:v:8:y:2008:i:3:p:321-334

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Related research

Keywords: Credit default swaps; Market liquidity; Bid-ask spreads; Autonomous credit risk; Risk premium;

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References

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  1. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "A Theory of the Term Structure of Interest Rates," Econometrica, Econometric Society, vol. 53(2), pages 385-407, March.
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Citations

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Cited by:
  1. Kwamie Dunbar, 2009. "The Effects of Credit Risk on Dynamic Portfolio Management: A New Computational Approach," Working papers 2009-03, University of Connecticut, Department of Economics, revised Feb 2009.
  2. Michele Leonardo Bianchi, 2012. "An empirical comparison of alternative credit default swap pricing models," Temi di discussione (Economic working papers) 882, Bank of Italy, Economic Research and International Relations Area.
  3. Bühler, Wolfgang & Trapp, Monika, 2009. "Time-varying credit risk and liquidity premia in bond and CDS markets," CFR Working Papers 09-13, University of Cologne, Centre for Financial Research (CFR).
  4. Rösch, Christoph G. & Kaserer, Christoph, 2013. "Market liquidity in the financial crisis: The role of liquidity commonality and flight-to-quality," Journal of Banking & Finance, Elsevier, vol. 37(7), pages 2284-2302.
  5. Dunbar, Kwamie & Amin, Abu S., 2012. "Credit risk dynamics in response to changes in the federal funds target: The implication for firm short-term debt," Review of Financial Economics, Elsevier, vol. 21(3), pages 141-152.

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