Derivative pricing with liquidity risk: Theory and evidence from the credit default swap market, The Journal of Finance 66

Evidence from the Credit Default Swap Market We derive a theoretical asset pricing model for derivative contracts that al-lows for expected liquidity and liquidity risk. Our model extends the LCAPM of Acharya and Pedersen (2005) to a setting with derivative instruments. The sign of the liquidity effect depends on investor heterogeneity in non-traded risk exposure, risk aversion and wealth. We estimate this model for the market of credit default swaps using a two pass regression approach. We find evidence for an economically and statistically significant expected liquidity premium earned by the protection seller. We do not find strong evidence that liquidity risk is priced. The relation between liquidity and asset prices has received considerable attention recently. However, much less is known about liquidity effects in derivative markets. This paper provides a theoretical model of liquidity effects in derivative markets and estimates this model for the credit default swap market. Recent market developments suggest that the credit default swap (CDS) market is subject to shocks in liquidity, an