Credit Derivatives and the Cost of Capital

Abstract:     
We examine the effects of credit derivatives on equilibrium debt contracts when investors have heterogeneous beliefs, with particular focus on naked credit default swaps. Although such contracts are zero-sum side bets, their existence can have important consequences. They induce investors who are most optimistic about borrower revenues, and would therefore be natural purchasers of debt, to sell credit protection instead. This diverts capital away from potential borrowers and channels it into collateral to support speculative positions. The resulting shift in the cost of debt can result in an increased likelihood of default and the amplification of rollover risk.

Number of Pages in PDF File: 41

Keywords: Speculative side bets, naked credit default swaps, heterogeneous beliefs, cost of capital

JEL Classification: D53, G10, G28, G32

working papers series