CDS Auctions and Informative Biases in CDS Recovery Rates

Abstract

Introduced in 2005 to identify recovery rates and so facilitate cash settlement in the multi-trillion dollar credit default swap market, credit-event auctions have a novel and complex two-stage structure that makes them distinct from other auction forms. Examining the efficacy of the auction's price-discovery process, we find that the auction price has a significant bias relative to pre- and post-auction market prices for the same instruments, and that volatility of market prices often increases after the auction. Nonetheless, we find that the auction generates information that is critical for post-auction market price formation. Auction outcomes are heavily influenced by strategic considerations and "winner's curse" concerns that could explain the observed biases. Structural estimation of the auction carried out under some simplifying assumptions suggests that alternative auction formats could reduce the bias in the auction final price.

Keywords: Credit default swaps, CDS credit-event auctions, price discovery, underpricing bias, winner's curse, structural estimation of auctions