American Economic Journal: Microeconomics, Forthcoming
41 Pages Posted: 6 Aug 2010 Last revised: 10 Sep 2013
Date Written: August 6, 2010
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: 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