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Time-varying credit risk and liquidity premia in bond and CDS markets

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  • Bühler, Wolfgang
  • Trapp, Monika
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    Abstract

    We develop a reduced-form model that allows us to decompose bond spreads and CDS premia into a pure credit risk component, a pure liquidity component, and a component measuring the relation between credit risk and liquidity. CDS liquidity has important consequences for the bond credit risk and liquidity components. Besides the credit risk link, we document a liquidity link between the bond and the CDS market. Liquidity in both markets dries up as credit risk increases, and higher bond market liquidity leads to lower CDS market liquidity. Ignoring CDS liquidity results in partly negative liquidity premia, particularly when CDS liquidity is low. --

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    Bibliographic Info

    Paper provided by University of Cologne, Centre for Financial Research (CFR) in its series CFR Working Papers with number 09-13.

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    Date of creation: 2009
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    Handle: RePEc:zbw:cfrwps:0913

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    1. Dimitri Vayanos, 2004. "Flight to Quality, Flight to Liquidity, and the Pricing of Risk," NBER Working Papers 10327, National Bureau of Economic Research, Inc.
    2. Olivier Renault & Jan Ericsson, 2000. "Liquidity and Credit Risk," FMG Discussion Papers dp362, Financial Markets Group.
    3. Kwamie Dunbar, 2008. "US corporate default swap valuation: the market liquidity hypothesis and autonomous credit risk," Quantitative Finance, Taylor & Francis Journals, vol. 8(3), pages 321-334.
    4. Alessandro Beber & Michael W. Brandt & Kenneth A. Kavajecz, 2006. "Flight-to-Quality or Flight-to-Liquidity? Evidence From the Euro-Area Bond Market," NBER Working Papers 12376, National Bureau of Economic Research, Inc.
    5. Menachem Brenner, 2001. "The Price of Options Illiquidity," Journal of Finance, American Finance Association, vol. 56(2), pages 789-805, 04.
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    Cited by:
    1. Rose, Andrew K. & Spiegel, Mark M., 2012. "Dollar illiquidity and central bank swap arrangements during the global financial crisis," Journal of International Economics, Elsevier, vol. 88(2), pages 326-340.
    2. Victor Lapshin & Marat Kurbangaleev, 2013. "A joint non-parametric approach to the decomposition of bond yields and CDS spreads: application of Eurozone market data," HSE Working papers WP BRP 13/FE/2013, National Research University Higher School of Economics.
    3. Luciana Barbosa & Sónia Costa, 2010. "Determinants of sovereign bond yield spreads in the euro area in," Working Papers w201022, Banco de Portugal, Economics and Research Department.

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