Credit markets and liquidity

In the light of the events of the recent financial crisis and of the increased importance of liquidity for the functionality of firms and financial markets, this thesis studies how a lack of liquidity (illiquidity) can affect the prices of credit derivatives and how illiquidity can propagate across credit and equity markets. The thesis incorporates three self-contained research papers. The first paper (Chapter 2) examines the effect of liquidity on the pricing of senior structured and unstructured credit indices (Senior Tranche of CDX.NA.IG Index and AAA Corporate Bond Index) over the period 2006-2009. The paper reveals that for both instruments the credit spreads align over time with the returns and the volatility of the equity market and with interest rates, as suggested by the structural model theory (Merton, 1974). However, it also shows that during the subprime crisis the highly-rated tranche of the CDX.NA.IG Index suffered from a substantial discount due to the lack of depth in the relevant markets, the scarcity of risk-capital, and the high liquidity preference exhibited by investors. By contrast, market liquidity and funding liquidity are found to be less significant in explaining the increase in the spread of the AAA Bond Index. The second paper (Chapter 3) investigates the existence of illiquidity commonality across equity and credit markets and the potential channels that can explain this phenomenon. Illiquidity appears to co-move across equities and credit default swaps in particular over crisis periods. For most firms, illiquidity is transmitted from one market (CDS) to the other (equity). Higher funding costs, market volatility and firms' systematic risk cause the equity-CDS illiquidity commonality to increase. However, the illiquidity commonality is also strongly related to the debt-to-equity hedge ratio which captures the arbitrage linkage between equity and CDSs. The paper shows that the illiquidity contagion across two fundamentally-linked assets can be generated by higher demand of liquidity for hedging and speculative trading. The third paper (Chapter 4) studies possible explanations for the credit spread puzzle. First, the paper shows that the credit spread puzzle can be partially explained by investors' aversion to a firm's extreme losses. The paper implements a novel calibration of the Merton (1974) model to a measure of sensitivity of CDS premia to equity volatility (which captures changes in the fat left tail of the firm's risk-neutral distribution). The predicted CDS premia are higher than those obtained using more traditional calibration methodologies, but still lower than those observed in the market. Therefore, the paper turns to studying the effects of investors' ambiguity aversion and CDS market illiquidity on CDS premia. The results show that when a market is illiquid and uncertainty is greater, sellers of credit default swaps charge more and CDS premia increase