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Abstract: We review different approaches for measuring the impact of liquidity on CDSprices. We start with reduced form models incorporating liquidity as anadditional discount rate. We review Chen, Fabozzi and Sverdlove 2008 andBuhler and Trapp 2006, 2008, adopting different assumptions on how liquidityrates enter the CDS premium rate formula, about the dynamics of liquidity rateprocesses and about the credit-liquidity correlation. Buhler and Trapp 2008provides the most general and realistic framework, incorporating correlationbetween liquidity and credit, liquidity spillover effects between bonds and CDScontracts and asymmetric liquidity effects on the Bid and Ask CDS premiumrates. We then discuss the Bongaerts, De Jong and Driessen 2009 study whichderives an equilibrium asset pricing model incorporating liquidity effects.Findings include that both expected illiquidity and liquidity risk have astatistically significant impact on expected CDS returns. We finalize ourreview with a discussion of Predescu et al 2009, which analyzes also datain-crisis. This is a statistical model that associates an ordinal liquidityscore with each CDS reference entity and allows one to compare liquidity ofover 2400 reference entities. This study points out that credit and illiquidityare correlated, with a smile pattern. All these studies highlight that CDSpremium rates are not pure measures of credit risk. Further research is neededto measure liquidity premium at CDS contract level and to disentangle liquidityfrom credit effectively.

Autor: Damiano Brigo, Mirela Predescu, Agostino Capponi



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