Derivative pricing with liquidity risk

Theory and evidence from the credit default swap market

Research output: Contribution to journalArticleScientificpeer-review

Abstract

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.
Original languageEnglish
Pages (from-to)203-240
Number of pages38
JournalJournal of Finance
Volume66
Issue number1
Publication statusPublished - 2011

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Liquidity risk
Credit default swaps
Derivative pricing
Risk theory
Derivatives
Assets
Seller
Short selling
Hedging
Investors
Wealth
Asset pricing models
Liquidity premium
Risk aversion
Risk exposure
Pricing
Credit
Expected returns

Cite this

@article{420e48624dd94287ae7009511ee35391,
title = "Derivative pricing with liquidity risk: Theory and evidence from the credit default swap market",
abstract = "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.",
author = "D. Bongaerts and {de Jong}, F.C.J.M. and J.J.A.G. Driessen",
note = "Pagination: 38",
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pages = "203--240",
journal = "The Journal of Finance",
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Derivative pricing with liquidity risk : Theory and evidence from the credit default swap market. / Bongaerts, D.; de Jong, F.C.J.M.; Driessen, J.J.A.G.

In: Journal of Finance, Vol. 66, No. 1, 2011, p. 203-240.

Research output: Contribution to journalArticleScientificpeer-review

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N2 - 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.

AB - 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.

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JO - The Journal of Finance

JF - The Journal of Finance

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