  We review different approaches for measuring the impact of liquidity on CDS
prices. We start with reduced form models incorporating liquidity as an
additional discount rate. We review Chen, Fabozzi and Sverdlove (2008) and
Buhler and Trapp (2006, 2008), adopting different assumptions on how liquidity
rates enter the CDS premium rate formula, about the dynamics of liquidity rate
processes and about the credit-liquidity correlation. Buhler and Trapp (2008)
provides the most general and realistic framework, incorporating correlation
between liquidity and credit, liquidity spillover effects between bonds and CDS
contracts and asymmetric liquidity effects on the Bid and Ask CDS premium
rates. We then discuss the Bongaerts, De Jong and Driessen (2009) study which
derives an equilibrium asset pricing model incorporating liquidity effects.
Findings include that both expected illiquidity and liquidity risk have a
statistically significant impact on expected CDS returns. We finalize our
review with a discussion of Predescu et al (2009), which analyzes also data
in-crisis. This is a statistical model that associates an ordinal liquidity
score with each CDS reference entity and allows one to compare liquidity of
over 2400 reference entities. This study points out that credit and illiquidity
are correlated, with a smile pattern. All these studies highlight that CDS
premium rates are not pure measures of credit risk. Further research is needed
to measure liquidity premium at CDS contract level and to disentangle liquidity
from credit effectively.
