The Role of Liquidity and Funding Frictions in Credit Risk Pricing: Insights from the CDS–Bond Relationship of JPMorgan Chase

Abstract

This paper examines the use of Credit Default Swaps (CDS) for hedging credit risk, with a specific focus on the practices of a major dealer bank, JPMorgan Chase & Co. While CDS spreads are recognized as a relatively pure measure of default risk and often lead bond markets in price discovery, corporate bond spreads additionally embed significant liquidity, funding, and tax components. This divergence means a CDS-only hedge is insufficient to neutralize P&L volatility in cash bond inventories. We propose an integrated hedging framework: using CDS as a primary overlay for default risk and an early-warning indicator, then combining them with cash-bond or asset-swap legs to manage the resultant basis and liquidity risks. This approach must be dynamic, especially under market stress when funding shocks and margin calls can widen basis spreads. The strategy is underpinned by a strong balance sheet, which allows for maintaining hedges during dislocations. The study concludes that effective credit risk management requires a dual approach that addresses both default and non-default components of credit spreads, with implications for bank-level risk management, market efficiency, and financial stability policy.