Liquidity and CDS Premiums on European Companies Around the Subprime Crisis

This paper sheds new light on the liquidity dynamics of the credit default swaps (CDS) market in Europe around the Subprime crisis. Based on an original dataset of 94 European companies from 2005 to 2009, we use a panel regression analysis to study the relationship between CDS premiums and liquidity. We measure the level of liquidity, look at liquidity risk, and study the liquidity spillovers from the bond and equity markets to the CDS market. We show that the effect of liquidity on CDS premiums is dominated by the influence of worsening credit conditions and deteriorating investors' expectations about default risk. Controlling for credit risk, we also find that liquidity risk is priced in the European CDS market and that liquidity spillovers from the bond market matter in determining CDS premiums