A Search-Based Pricing Model of Credit Default Swaps

Abstract

We characterize the equilibrium spreads of Credit Default Swaps traded in an over-the-counter market. The OTC market involves a continuum of traders indexed by their beliefs about risk. Traders encounter standard search frictions. Once agents are matched, they adjust their preferred spread according to their subjective risk measures of both the reference entity and their counterparty. In the absence of search frictions, agents do not consider counterparty risk in determining the optimal spread. Under the assumption that buyers do not own the underlying debt, gainful trade occurs only when beliefs about risk differ. When buyers own the debt, the spread grows and gainful trade can occur even when beliefs about risk coincide. The limiting spread is the risk-neutral spread up to an affine transformation.

Keywords: Search Theory, Credit Defualt Swaps, Over the Counter Markets, Dynamic Equilibrium, Dynamic Programming, Derivatives, Systemic Risk, Counterparty Risk