In this study, we use a factor model in order to decompose CDS spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present better decomposition and more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly impacted by liquidity risk (i.e 50% of default risk and 49.91% of liquidity risk) and that sovereign bond spreads are less subject to liquidity frictions and therefore represent a better poxy for sovereign default risk (i.e 97.08% of default risk and 1.73% of liquidity risk). Furthermore, our model extension enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. Although these risks do have an influence on the default intensity, the magnitude of their impact is small and therefore they do not contribute significantly to spread movements.
In this study, we use a factor model in order to decompose CDS spreads into default, liquidity, systematic liquidity and correlation components. By calibrating the model to sovereign CDSs and bonds we are able to present better decomposition and more accurate measure of spread components. Our analysis reveals that sovereign CDS spreads are highly impacted by liquidity risk (i.e 50% of default risk and 49.91% of liquidity risk) and that sovereign bond spreads are less subject to liquidity frictions and therefore represent a better poxy for sovereign default risk (i.e 97.08% of default risk and 1.73% of liquidity risk). Furthermore, our model extension enables us to directly study the effect of systematic liquidity and flight-to-liquidity risks on bond and CDS spreads through the factor sensitivity matrix. Although these risks do have an influence on the default intensity, the magnitude of their impact is small and therefore they do not contribute significantly to spread movements.
In this study, we focus on the dynamic properties of the risk-neutral liquidity risk premium specic to the sovereign credit default swap (CDS) and bond markets.We show that liquidity risk has a non-trivial role and participates directly to the variation over time of the term structure of sovereign CDS and bond spreads for both the pre-and crisis periods. Secondly, our results indicate that the timevarying bond and CDS liquidity risk premium move in opposite directions which imply that when bond liquidity risk is high, CDS liquidity risk is low (and vice versa), which may in turn be consistent with the substitution eect between CDS and bond markets. Finally, our Granger causality analysis reveals that, although the magnitude of bond and CDS liquidity risk are substantially dierent, there is a strong liquidity ow between the CDS and the bond markets, however no market seems to consistently lead the other.JEL Classications: G00, G12, G13. Keywords: Term structure of sovereign credit default swaps, Maximum likelihood, Kalman lter, Risk neutral measure and Liquidity risk.
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