Hedging Credit: Equity liquidity matters
by Sanjiv R. Das of Santa Clara University, and
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.
Keywords: Credit default swap, Basis, Liquidity
Published in: Journal of Financial Intermediation, Vol. 18, No. 1, (January 2009), pp. 112-123.