Derivative pricing with liquidity risk: Theory and evidence from the credit default swap market

We derive a theoretical asset-pricing model for derivative contracts that allows for expected liquidity and liquidity risk, and estimate this model for the market of credit default swaps (CDS). Our model extends the LCAPM of Acharya and Pedersen (2005) to a setting with derivative instruments and shows that the sign of the liquidity effects depends on investor heterogeneity in non-traded risk exposure, risk aversion and wealth. Empirically, the model is estimated by applying the standard two-pass regression approach to CDS portfolios, for which we construct liquidity and return time series using a repeated sales methodology. Expected CDS returns are calculated by correcting CDS spreads for the expected loss. We find evidence for an economically and statistically significant expected liquidity premium earned by the protection seller. In line with our theoretical predictions, we do not find strong evidence that liquidity risk is priced.