Credit Market Speculation and the Cost of Capital

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