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Extracting Liquidity Risk Factors by Credit Default Swap Quotation and Corporate Bond Yield:
An Experimental Investigation

and the market price of default risk. This indicates liquidity and default risk factors can
well explain CDS premium change. This finding allows us to examine the residuals of
regression equations as basic elements of extracting liquidity factors.
Furthermore, in order to investigate which liquidity factors can better explain market

information, we implement several empirical tests to examine whether the liquidity factors
have different impacts on market liquidity proxies represented by CDS bid-ask spread
and trading volume of corporate bonds. In addition, we implement ADF test to examine

whether liquidity factors are stationary in order to further conduct robustness checks.

3. Findings

The ADF test results reveal that these two liquidity factors extracted are stationary.

Hence, we resolve the concern regarding whether spurious correlations among dependent
variables will appear in further regressions. Moreover, the total variations explained by
the first two components estimated using CDS premiums accounts for over 80% of total
variations. The result indicates that principal component analysis would be a reasonable

tool in our estimation.
Then we conduct an empirical test to compare which liquidity factors can have
better relationship with the traditional liquidity measure. The test shows that liquidity
risk factor estimated in this paper can be good proxies for liquidity risk. We discover that

the liquidity risk factor extracted from CDS market quotations combined with corporate
bond yield rates has more goodness of fit than the other factor extracted purely from
CDS market quotations. It is demonstrated that the liquidity factor extracted from CDS
market quotations combined with corporate bond yield rates is more significantly related

to interest rate measures than the one extracted from pure CDS market quotations. The
results are still the same even after we add in some macroeconomic variables as control
variables. Therefore, we conclude that the liquidity factor extracted from CDS market
quotations combined with corporate bond yield rates can be a better alternative.

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