Liquidity and Counterparty Risk in OTC Markets

I study dispersion of CDS premia in a theoretical over-the-counter (OTC) economy. Agents have heterogeneous expectations about counterparty and reference entity default rates. In equilibrium, spreads of CDS contracts vary based on counterparty characteristics even if reference entity risk is fixed. Price distortions from counterparty risk are more pronounced in markets with less liquidity. Heterogeneous beliefs imply agents do better than break-even from trade in expectation. I derive an equilibrium pricing kernel that allocates expected gains from trade between counterparties based on their beliefs and relative bargaining power. The model suggests central clearing counterparties will have more impact on prices in markets that are less liquid. I show the widely-used risk-neutral CDS spread is a special case of the spread obtained in the search model