Hedging Credit: Equity Liquidity Matters

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 (1974) model via hedging. We confirm this relationship empirically using a sample of 1,452 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