Hedging credit: Equity liquidity matters |
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Authors: | Sanjiv R Das Paul Hanouna |
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Institution: | 1. Santa Clara University, Leavey School of Business, 500 El Camino Real, Santa Clara, CA 95053, USA;2. Villanova University, Villanova School of Business, 800 Lancaster Avenue, Villanova, PA 19085, USA |
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Abstract: | We theorize and confirm a new channel by means of which liquidity costs are embedded in CDS spreads. We show that credit default swap (CDS) spreads are directly related to equity market liquidity in the Merton Merton, R.C., 1974. On the pricing of corporate debt: The risk structure of interest rates. J. Finance 29, 449–470] model via hedging. We confirm this relationship empirically using a sample of 1452 quarterly CDS spreads over 2001–2005. In the model, this relationship is monotone increasing when credit quality worsens. These results are robust to alternative measures of equity liquidity and other possible determinants of CDS spreads. |
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