Types of Liquidity and Limits to Arbitrage - The Case of Credit Default Swaps

Using a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period 6/2008 to 9/2009, we show that funding-liquidity (shadow cost of capital for arbitrageurs) as well as asset specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage based parity relationship between the CDS prices and bond yield spreads (CDS-Bond spread basis). Collectively our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these two types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding period of 127 days, but the path to convergence is not smooth