Liquidity basis between credit default swaps and corporate bonds markets

Abstract

Liquidity risk has drawn much attention among academic researchers, institutional professionals and financial regulators in various financial markets. This paper empirically investigates the difference and relationship between the liquidities of CDS and corporate bond markets. The liquidity basis which is defined as the difference of liquidity between CDS and corporate bond are negative most of the time across different rating categories, implying more illiquid corporate bond market and the fact that CDS market moves quickly in reflecting credit quality changes. There exists significant Granger-causality from CDS liquidity to bond liquidity, and some bidirectional Granger-causality for some investment grade reference entities. The empirical tests are performed in the VAR system including the monetary policy variables and financial market variables. The relative bid-ask spread adopted by many researchers turns out to be less reliable as a measure of liquidity for CDS and corporate bond where the credit spread and liquidity risk are positively correlated.