Credit Default Swaps Liquidity Modeling : A Survey

We review different theoretical and empirical approaches for measuring the impact of liquidity on CDS prices. We start by reduced form models incorporating liquidity as an additional discount rate. We review Chen, Fabozzi and Sverdlove (2008) and Buhler and Trapp (2006, 2008), adopting different assumptions on how liquidity rates enter the CDS premium rate formula, about the dynamics of liquidity rate processes and about the credit-liquidity correlation. Buhler and Trapp (2008) provides the most general and realistic framework, incorporating correlation between liquidity and credit, liquidity spillover effects between bonds and CDS contracts and asymmetric liquidity effects on the Bid and Ask CDS premium rates.We then discuss the Bongaerts, De Jong and Driessen (2009) study which derives an equilibrium asset pricing model incorporating liquidity effects. Findings include that both expected illiquidity and liquidity risk have a statistically significant impact on expected CDS returns, but only compensation for expected illiquidity is economically significant with higher expected liquidity being associated with higher expected returns for the protection sellers. This finding is contrary to Chen, Fabozzi and Sverdlove (2008) that found protection buyers to earn the liquidity premium instead.We finalize our review with a discussion of Predescu et al (2009), which analyzes also data in-crisis. This is a statistical model that associates an ordinal liquidity score with each CDS reference entity and allows one to compare liquidity of over 2400 reference entities. This study points out that credit and illiquidity are correlated, with a smile pattern.All these studies highlight that CDS premium rates are not pure measures of credit risk. CDS liquidity varies cross-sectionally and over time. CDS expected liquidity and liquidity risk premia are priced in CDS expected returns and spreads. Further research is needed to measure liquidity premium at CDS contract level and to disentangle liquidity from credit effectively