Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets

We provide a model of nonredundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: it crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become lev...

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Bibliographic Details
Published in:The Review of financial studies 2015-12, Vol.28 (12), p.3303-3337
Main Authors: Oehmke, Martin, Zawadowski, Adam
Format: Article
Language:English
Subjects:
Bond markets
Cost analysis
Credit default swaps
Equilibrium
Studies
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Summary:We provide a model of nonredundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: it crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhv047