Time-Varying Credit Riskand Liquidity Premia inBond and CDS Markets

We develop a reduced-form model that allows us to decompose bond spreads and CDS premiainto a pure credit risk component, a pure liquidity component, and a component measuring therelation between credit risk and liquidity. CDS liquidity has important consequences for the bondcredit risk and liquidity components. Besides the credit risk link, we document a liquidity linkbetween the bond and the CDS market. Liquidity in both markets dries up as credit risk increases,and higher bond market liquidity leads to lower CDS market liquidity. Ignoring CDS liquidity resultsin partly negative liquidity premia, particularly when CDS liquidity is low.