This paper develops a reduced form three-factor model which includes a liquidity proxy of market conditions which is then used to provide implicit prices. The model prices are then compared with observed market prices of credit default swaps to determine if swap rates adequately reflect market risks. The findings of the analysis illustrate the importance of liquidity in the valuation process. Moreover, market liquidity, a measure of investors. willingness to commit resources in the credit default swap (CDS) market, was also found to improve the valuation of investors. autonomous credit risk. Thus a failure to include a liquidity proxy could underestimate the implied autonomous credit risk. Autonomous credit risk is defined as the fractional credit risk which does not vary with changes in market risk and liquidity conditions.

Are the managers of financial institutions ready for the small but increasingly significant risk of inflation in the near future, due to the unprecedented fiscal and monetary responses of the US government to prevent an economic collapse? This paper addresses this important issue by reviewing important findings in the area of interest rate risk management. We discuss five classes of models in the fixed income literature that deal with hedging the risk of large, nonparallel yield curve shifts. These models are given as (i) M-absolute/M-square models, (ii) duration vector/M-vector models, (iii) key rate duration models, (iv) principal component duration models, and (v) extensions of these models for fixed income derivatives, for valuing and hedging bonds, loans, demand deposits, and other fixed income instruments. These models can be used for designing various hedging strategies such as portfolio immunization, bond index replication, duration gap management, and contingent immunization, to protect against changes in the height, slope, and curvature of the yield curve. We argue that the current regulatory models proposed by the US Federal Reserve, the Office of Thrift Supervision, and the Bank of International Settlements may understate the true interest rate risk exposure of financial institutions, if sharp increases in interest rates lead to higher default risk and quickening of the pace of deposit withdrawals. 1