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

Review of Financial Studies, 2015, 28(12):3303-3337

Columbia Business School Research Paper No. 13-85

56 Pages Posted: 20 Nov 2013 Last revised: 7 Nov 2015

See all articles by Martin Oehmke

Martin Oehmke

London School of Economics & Political Science (LSE) - Department of Finance; Centre for Economic Policy Research (CEPR)

Adam Zawadowski

Boston University - Department of Finance & Economics

Date Written: July 13, 2015

Abstract

We provide a model of non-redundant 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.

Keywords: Credit Default Swaps, Bonds, Trading Costs, Liquidity , Bond yield, CDS-bond basis, Non-redundant derivatives

Suggested Citation

Oehmke, Martin and Zawadowski, Adam, Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets (July 13, 2015). Review of Financial Studies, 2015, 28(12):3303-3337, Columbia Business School Research Paper No. 13-85, Available at SSRN: https://ssrn.com/abstract=2357161 or http://dx.doi.org/10.2139/ssrn.2357161

Martin Oehmke

London School of Economics & Political Science (LSE) - Department of Finance ( email )

United Kingdom

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Adam Zawadowski (Contact Author)

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

HOME PAGE: http://people.bu.edu/zawa

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
233
Abstract Views
1,317
Rank
238,301
PlumX Metrics