Liquidity tail risk and credit default swap spreads

We show that liquidity tail risk in credit default swap (CDS) spreads is time-varying and explains variation in CDS spreads. We capture the liquidity tail risk of a CDS contract written on a firm by estimating the tail dependence, i.e., the asymptotic probability of a joint surge in the bid-ask spread of the firm's CDS and the illiquidity of a CDS market index. Our results show that protection sellers earn a statistically and economically significant premium for bearing the risk of joint extreme downwards movements in the liquidity of individual CDS contracts and the CDS market. This effect holds in various robustness checks such as instrumental variable regressions and alternative liquidity measures and is particularly pronounced during the financial crisis.