Credit Market Speculation and the Cost of Capital

American Economic Journal: Microeconomics, Forthcoming

41 Pages Posted: 6 Aug 2010 Last revised: 10 Sep 2013

Yeon-Koo Che

Columbia University

Rajiv Sethi

Columbia University, Barnard College - Department of Economics; Santa Fe Institute

Date Written: August 6, 2010

Abstract

We examine the effects of speculation using credit derivatives on the cost of debt and the likelihood of default. The availability of credit default swaps induces investors who are optimistic about borrower revenues to sell protection instead of buying bonds. This benefits borrowers if protection can only be bought with an insurable interest, but can increase the cost of debt and crowd out productive lending if protection can be purchased as a bet on default. We also show that the possibility of speculation on default may cause multiple equilibria and exacerbate the problem of rollover risk.

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

JEL Classification: D53, G10, G28, G32

Suggested Citation

Che, Yeon-Koo and Sethi, Rajiv, Credit Market Speculation and the Cost of Capital (August 6, 2010). American Economic Journal: Microeconomics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1654222 or http://dx.doi.org/10.2139/ssrn.1654222

Yeon-Koo Che (Contact Author)

Columbia University ( email )

420 W. 118th Street
New York, NY 10027

Rajiv Sethi

Santa Fe Institute

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Columbia University, Barnard College - Department of Economics ( email )

3009 Broadway
New York, NY 10027
United States
212-854-5140 (Phone)
212-854-8947 (Fax)

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