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Abstract
We show that extreme liquidity risk is a significant driver of credit default swap (CDS) spreads. We capture the extreme liquidity risk of a CDS contract written on a firm by estimating the tail dependence between the bid-ask spread of the firm's CDS and the liquidity of a CDS market index. Our results show that sellers of credit protection earn a statistically and economically significant premium for bearing the risk of joint extreme downwards movements in the liquidity of individual CDS contracts and the CDS market. This effect holds in various robustness checks and is particularly pronounced during the financial crisis. Finally, we discuss the implications of our findings for insurers and pension funds that enter the CDS market to take on credit risk.
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