Are CDS Auctions Biased?

Abstract:     
We study the design of settlement auctions for credit default swaps (CDS). We find that the one-sided design of CDS auctions currently used in practice gives CDS buyers and sellers strong incentives to distort the final auction price, in order to profit from existing CDS positions. In the absence of frictions, the current auction mechanism tends to overprice defaulted bonds given an excess supply and underprice them given an excess demand. We propose a double auction to mitigate price biases and provide robust price discovery. The predictions of our theory on bidding behavior are consistent with CDS auction data.

Number of Pages in PDF File: 49

Keywords: Credit Default Swaps, Credit Event Auctions, Price Bias, Double Auction

JEL Classification: G12, G14, D44

working papers series