Studies on corporate risk management and derivatives use commonly view derivatives as hedging instruments (e.g., Smith and Stulz, 1985; Rogers, 2002; Aretz and Bartram, 2010). The role of credit derivatives as credit risk management instruments in banks is widely acknowledged (e.g., Hirtle, 2009; Nijskens and Wagner, 2011). Banks have dominated the credit derivatives market, in which CDS are the most commonly used credit derivatives globally (British Bankers’ Association (BBA), 2006; Minton et al., 2009; International Swaps and Derivatives Association (ISDA), 2010). However, the incentives underlying the use of CDS and the effectiveness of such credit risk management remain unknown (Minton et al., 2009). Our study contributes to filling this gap. CDS allow the transfer of credit risk across firms, whereby buying CDS allows a bank to short exposure to credit risk at a known cost (i.e., insurance premium). From the buyer’s perspective, the economic effect of a CDS contract is similar to that of an insurance contract, because it protects the buyer against the default of the underlying asset during the life of the contract (Duffee and Zhou, 2001). This protection is important for banks that are constantly exposed to the credit or default risks of risky assets (e.g., loans and mortgages). We can expect that banks with hedging motives or those managed by risk-averse managers are more likely to buy CDS that transfer the credit risks of risky assets to the sellers of such derivatives. However, bank managers are not always risk-averse, because their risk-taking appetites would enhance when stock options are included in their pay packages. Studies on executive compensation suggest that equity-based pay, such as stock options, had induced risk-taking behaviours among bank managers in the build-up of the 2007-2008 crisis (e.g., Bebchuk et al., 2010; Fortin et al., 2010; Minhat and Abdullah, 2016). Some studies also suggest that stock options can discourage managers from hedging risk (e.g., Smith and Stulz, 1985; Tufano, 1996; Rajgopal and Shevlin, 2002; Aretz and Bartram, 2010; Bakke et al., 2016). This is because stock options contain an important feature that can induce, rather than restrain, managers’ risk-taking appetites. This feature is described as vega, which measures the extent of risk-taking incentives induced by stock options (Guay, 1999; Rogers, 2002; Coles et al., 2006; Minhat and Abdullah, 2016). Vega is the measurement of a stock option’s sensitivity to the volatility (or risk) of the underlying stock. Because the value of a stock option is positively related to the volatility of the underlying stock, the presence of vega will discourage managers from hedging against risk or volatility (e.g., Rajgopal and Shevlin, 2002; Aretz and Bartram, 2010). If hedging against credit risk can reduce a bank’s stock volatility (Nijskens and Wagner, 2011), then that risk management strategy is not in the best interest of managers who wish to increase the value of their stock options. Therefore, we conjecture that vega will provide bank managers with little incentive to buy CDS for hedging purposes.

Over the past decades, the emergence and growth of credit derivatives markets have provided market participants with additional ways to invest in credit risk. Especially insurers, mutual funds, and pension funds entered these markets as net protection sellers as credit derivatives provided them with previously unattainable risk-return profiles. During the financial crisis, however, investments in credit derivatives markets exposed several insurers to extreme tail risk when both prices and illiquidity in the market for credit default swaps (CDS) as the most widely used credit derivative surged during the height of the crisis. In the case of the most prominent example of such an insurer, American International Group (AIG) faced bankruptcy and had to be bailed out as the U.S. government deemed AIG to be systemically important due to its involvement in the CDS market. Consequently, economists and regulators alike have taken a strong interest in investigating the role crash and liquidity risk play for investors in the CDS market. In this study, we try to answer the question whether liquidity tail risk is a significant driver of CDS spreads. We define a firm’s CDS contract’s liquidity tail risk as the propensity of the contract to experience a joint crash in its liquidity together with the liquidity of the CDS market. To measure this propensity, we propose the use of a dynamic copula model to estimate the asymptotic probability of both spread series jointly being in their extreme upper tail (i.e., their upper tail dependence). As a first result, we find average liquidity tail risk to be of small magnitude (about 0.2%) before the financial crisis. During the crisis, however, average liquidity tail risk almost doubled after the bailout of AIG and tripled at the start of 2009. We then estimate panel regressions of monthly CDS spreads on several proxies of liquidity tail risk in the CDS market and various controls. Our results confirm that the risk of a joint liquidity crash in the CDS market is significantly related to CDS spreads with sellers of credit protection demanding a premium for bearing liquidity tail risk.