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Are European Corporate Bond and Default Swap Markets Segmented?

by Didier Cossin of IMD, Lausanne, and
Hongze Lu of IMD & HEC, University of Lausanne,

November 28, 2005

Abstract: Market prices of corporate bond spreads and of credit default swap (CDS) rates do not match each other. In this paper, we argue that the liquidity premium, the cheapest-to-deliver (CTD) option and actual market segmentation explain the pricing differences. Using the European transaction data from Reuters and Bloomberg, we estimate the liquidity premium that is time varying and firm-specific. We show that when time-dependent liquidity premiums are considered, corporate bond spreads and CDS rates behave in a much closer way than previous studies have shown. We find that high equity volatility drives pricing differences that can be explained by the CTD option.

JEL Classification: C13, G12, G13.

Keywords: credit default swaps, corporate bond yields, liquidity premium, cheapest-to-deliver options, debt-CDS arbitrage.

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