CDS Markets: Liquidity, Default Risk, and Correlation Risk

The project aims at getting a better understanding of the properties of CDS markets and thereby extracting information related to financial institutions and markets that is relevant for supervision. Models for CDS are designed and implemented to investigate the interrelation between CDS markets, bond markets, and equity-option markets.

A state-space model is applied to decompose bid and ask quotes of CDS into two components, fair default premium and liquidity premium. The model-generated output variables are analyzed in a difference-in-difference framework to determine how the default premium as well as the liquidity premium of protection buyers and sellers evolved during different periods of the financial crisis and to which extent they differ for financial institutions compared to non-financials.

Moreover, a distress factor is extracted from CDS prices. In particular, we elaborate a default model that isolates from CDS spreads a long-term and a short-term default risk factor, whereby the short-term factor can be interpreted as a measure of financial distress. 

• The liquidity premium widens for the protection seller and the protection buyer in absolute terms during the crisis.
• The protection buyer receives a larger liquidity premium than the protection seller.
• During the crisis, the share of the liquidity premium earned by the protection seller increases, in particular for non-financials.
• This is at the cost of the protection buyer, since the relative liquidity premium of the protection buyer decreases strongly after the beginning of the financial downturn while that of the protection seller hardly changes.
• Protection sellers generally require a lower liquidity premium for financial names than non-financial names. To our knowledge, this is the first paper that attempts to explain the liquidity premium of the protection seller relative to the liquidity premium of the bidder during the financial crisis.