Hedging Credit: Equity liquidity matters

by Sanjiv R. Das of Santa Clara University, and
Paul Hanouna of Villanova University

January 2009

Abstract: Credit default swap (CDS) spreads are directly related to equity market liquidity in the Merton (1974) model via hedging. Empirical tests confirm this relationship. This relationship is monotone increasing when credit quality worsens. We theorize and confirm this new channel by means of which liquidity costs are embedded in CDS spreads.

JEL Classification: M41, G1, G12, C41, C52.

Keywords: Credit default swap, Basis, Liquidity

Published in: Journal of Financial Intermediation, Vol. 18, No. 1, (January 2009), pp. 112-123.

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