Liquidity Risk in Credit Default Swap Markets*

We show that liquidity risk is priced in the cross section of returns on credit de-fault swaps (CDSs). Liquidity risk is defined as covariation between CDS returns and a liquidity factor that captures innovations to CDS market liquidity. Market-wide CDS illiquidity is measured by aggregating deviations of credit index levels from their no-arbitrage values implied by the index constituents ’ CDS spreads, and the liquidity factor is the return on a diversified portfolio of index arbitrage strategies. Liquidity risk increases CDS spreads and the expected excess returns earned by sellers of credit pro-tection. Our benchmark model implies that liquidity risk accounts for approximately 20 % of CDS spreads, on average