Systematic and Firm-specific Risks of CDS Spreads: Credit and Liquidity under Scrutiny

Using a sample of 356 U.S. non-financial firms from 2002 to 2011, we derive endogenous systematic credit risk and Credit Default Swap (CDS) illiquidity factors, and show that they dominate firm-specific and exogenous market factors as determinants of individual firms’ CDS spreads. Our model performs well for cross-sectional predictions and can be used for estimating CDS spreads for firms that do not have traded CDSs. Our findings question Basel III’s adoption of CDS-implied probability for counterparty risk management, as CDS spread is not a pure individual firm default risk measure devoid of market credit and illiquidity premia.