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Are European Corporate Bond and Default Swap Markets Segmented?

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Author Info
Didier Cossin () (IMD International)
Hongze Lu () (IMD International, HEC, University of Lausanne)
Abstract

Market prices of corporate bond spreads and of credit default swap (CDS) rates do not match each other. In this paper, we argue that the liquidity premium, the cheapest-to-deliver (CTD) option and actual market segmentation explain the pricing differences. Using the European transaction data from Reuters and Bloomberg, we estimate a liquidity premium that is time-varying and firm-specific. We show that when time-dependent liquidity premiums are considered, corporate bond spreads and CDS rates behave in a much closer way than previous studies have shown. We also find that high equity volatility drives pricing differences that can be explained by the CTD option.

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Publisher Info
Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp133.

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Date of creation: Mar 2005
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Handle: RePEc:fam:rpseri:rp133

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Related research
Keywords: credit default swap; corporate bond yields; liquidity premium; cheapest-to-deliver options; debt-CDS arbitrage;

Find related papers by JEL classification:
C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Estimation
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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Cited by:
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  1. Jan De Wit, 2006. "Exploring the CDS-Bond Basis," Research series 200611-16, National Bank of Belgium. [Downloadable!]
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