On the compensation for illiquidity in sovereign credit markets

This article analyzes the role of liquidity in the sovereign credit default swap (CDS) market. We employ a continuous-time specification to incorporate illiquidity as an additional pricing factor of default swap contracts for the most developed economies. The illiquidity discount process is identified as compensation to investors for the risk of unwinding their positions when trading in the less liquid part of the curve, and the information about illiquidity is directly extracted from the term structure of sovereign CDS spreads. Our empirical findings reveal that a positive time-varying illiquidity premium is embedded in sovereign default swaps. These risk premia exhibit substantial comovement across countries. Only unidirectional causality from default to liquidity is detected for the overall market. We are exceptionally grateful to Jonatan Groba for his valuable comments and suggestions. J.A. Lafuente acknowledges financial support from the Spanish Ministry of Economy and Competitiveness through grant ECO2012-31941, the Generalitat Valenciana through grant PrometeoII/2013/015 and the University Jaume I through grant P1.1A2012-09. P. Serrano acknowl- edges financial support from the Spanish Ministry of Economy and Competitiveness through grant ECO2012-34268 and from Junta de Andalucía project P12-SEJ-1733.