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. 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 defaultswaps 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.

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