Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market

Dion Bongaerts, FCJM De Jong, JJAG Driessen

Research output: Contribution to journalArticleAcademicpeer-review

164 Citations (Scopus)

Abstract

We derive an equilibrium asset pricing model incorporating liquidity risk, derivative assets, and short-selling due to hedging of non-traded risk. We show that, both for positive-net-supply assets and derivatives, the sign of liquidity effects depends on investor heterogeneity in non-traded risk exposure, risk aversion, horizon and wealth. We also show that liquidity risk affects derivatives in a different way than positive-net-supply assets. We estimate this model for the credit default swap market using GMM. 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.
Original languageEnglish
Pages (from-to)203-240
Number of pages38
JournalThe Journal of Finance
Volume66
Issue number1
DOIs
Publication statusPublished - 2011

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