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





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    • Bongaerts is with Finance Group, RSM Erasmus University Rotterdam, and De Jong and Driessen are with the Department of Finance, Netspar, Tilburg University. A previous version of this paper was circulated under the title “Liquidity and Liquidity Risk Premia in the CDS Market.” We are grateful to Moody's KMV and Graeme Wood for providing the MKMV EDF data. We would like to thank Andrea Buraschi, Long Chen, Mike Chernov, Lasse Pedersen, Olivier Renault, Ilya Strebulaev, Marti Subrahmanyam, Akiko Watanabe, Avi Wohl, and participants in the Gutmann Symposium 2007, EFA 2007, Workshop on Default Risk Rennes 2007, the WFA meeting 2008, 2008 SIFR conference on credit markets, CREDIT 2008 Venice conference, Inquire Europe Symposium 2008, Erasmus Liquidity Conference and seminars at Imperial College, Maastricht University, Free University of Amsterdam, University of Kaiserslautern, University of Rotterdam, ABN-AMRO, Bank of England, the European Central Bank, Yale University, and Lancaster University. We especially thank Campbell Harvey, an anonymous associate editor, and two anonymous referees for many helpful comments and advice.


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.