Stock Liquidity as a Determinant of Credit Default Swap Spreads

Abstract: This research investigates the effect of stock liquidity on credit default swap spreads. The relationship between stock liquidity and CDS spreads is tested empirically using a panel data of 82 companies spanning a period of 64 months. To ensure the accuracy of our findings, we use three proxies for stock liquidity, namely the bid-ask spread, Amihud illiquidity measure and the turnover ratio. When controlling for other known firm-level factors, we obtain a relationship between stock liquidity measures and CDS spreads, indicating that higher stock liquidity leads to lower CDS spread. This relation also holds when macroeconomic factors are used as control variables. Thereby, we manage to find a link between the stock market and the CDS market. This relationship helps predict the movement of CDS spreads by analyzing stock liquidity in the developed equity market.