US Corporate Default Swap Valuation: The market liquidity hypothesis and autonomous credit risk
by Kwamie Dunbar of the University of Connecticut & Sacred Heart University
Abstract: This paper develops a reduced form three-factor model which includes a liquidity proxy of market conditions which is then used to provide implicit prices. The model prices are then compared with observed market prices of credit default swaps to determine if swap rates adequately reflect market risks. The findings of the analysis illustrate the importance of liquidity in the valuation process. Moreover, market liquidity, a measure of investors. willingness to commit resources in the credit default swap (CDS) market, was also found to improve the valuation of investors. autonomous credit risk. Thus a failure to include a liquidity proxy could underestimate the implied autonomous credit risk. Autonomous credit risk is defined as the fractional credit risk which does not vary with changes in market risk and liquidity conditions.
Keywords: Credit Default Swaps, Market Liquidity, Bid-Ask Spreads, Autonomous Credit Risk, Risk Premium.
Published in: Quantitative Finance, Vol. 8, No. 3, (April 2008), pp. 321-334.