The researchers from Henley Business School at the University of Reading analysed a sample of intraday corporate CDS trading prices and quotes from GFI, a prominent inter-dealer broker, for the period from January 2006 to July 2009. They found that CDS spread changes are driven mostly by liquidity factors regardless of market conditions so CDS prices should be used with caution in early warning systems and for valuation purposes.
From the start of the on-going financial crisis, credit spreads have been used as a key credit risk indicator. Obtained primarily from corporate and sovereign bonds and credit default swaps (but also implied from stock and options prices), credit spreads are commonly deemed to capture default risk.
In this study, the researchers aimed to determine to what extent credit spread changes are driven by default risk or liquidity risk. This is important because if liquidity risk plays a key role in credit spread movements, then their interpretation as default risk measures may be impaired and, as a result, misleading.
This could have serious implications not only because credit spread variations are taken as signals of changes in the financial strength of corporations and governments but also because they are often used for pricing financial assets.
Dr Alfonso Dufour, from Henley Business School’s ICMA Centre, said: “The sample period enabled us to investigate the default and liquidity determinants of CDS price changes before and during the so called ‘Great Recession’. Our results are striking.
“We discovered that CDS spread changes are driven mostly by liquidity factors regardless of market conditions, and therefore caution should be used when interpreting price changes in the CDS market. Clearly, international efforts to achieve greater transparency in the CDS market, central clearing arrangements and standardisation of CDS contracts are likely to reduce liquidity risk in the CDS market and consequently improve the reliability of CDS prices as the default risk barometer.”
A key aspect of the study was analysing the drivers of liquidity risk, specifically investigating informed trading.
Dr Dufour continued: “When the likelihood of informed trading increases, market makers try to reduce potential losses from trading with better informed investors by adjusting their prices more aggressively and increasing bid-ask spreads. We observe that the price impact of CDS trades was noticeably higher during the crisis, a clear indication of stronger protective measures being taken by market makers against investors with superior information. This indirectly supports concerns of insider trading in the CDS market often reported in the financial press and voiced by regulators.
“We also found evidence that during the pre-crisis period the greater level of transparency enjoyed by large companies through their higher disclosure standards helps reduce the uncertainty on the credit status of a firm and hence it reduces the informational advantage of informed traders. However, during the crisis we noticed a general increase in the level of uncertainty with respect to the financial conditions of all companies and hence we detect an increased fear of informed trading.”Reference Coro', F., Dufour, A. and Varotto, S. (2013) “The Time Varying Properties of Credit and Liquidity Components of CDS Spreads” SSRN working paper: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2011092