Derivative Pricing with Liquidity Risk: Theory and evidence from the credit default swap market
by Dion Bongaerts of RSM Erasmus University Rotterdam,
Abstract: We derive an equilibrium asset pricing model incorporating liquidity risk, derivatives, and short-selling due to hedging of nontraded risk. We show that illiquid assets can have lower expected returns if the short-sellers have more wealth, lower risk aversion, or shorter horizon. The pricing of liquidity risk is different for derivatives than for positive-net-supply assets, and depends on investors' net nontraded risk exposure. We estimate this model for the credit default swap market. We find strong evidence for an expected liquidity premium earned by the credit protection seller. The effect of liquidity risk is significant but economically small.
Published in: Journal of Finance, Vol. 66, No. 1, (February 2011), pp. 203-240.
Previously titled: Liquidity and Liquidity Risk Premia in the CDS Market