Financial Oligopolies: Theory and Empirical Evidence in the Credit Default Swap Markets

Abstract

We formulate a Cournot-type market equilibrium model of simultaneous trading in the CDS and Loan CDS (LCDS) markets. We use novel formulations of two-market demand functions that include trading costs and margins. The equilibrium identifies a relation between premiums, elasticities and recovery rates in both markets. The relation under perfect competition coincides with the one that prevails under no-arbitrage. The oligopoly version of the relation is consistent with observed significantly positive and persistent earnings from simulated portfolios of a large number of matured contracts in the two markets. Extensive empirical tests confirm the model’s predictions and decisively reject competing theories.

Keywords: Oligopolies, Market Structure, Barriers to Entry, (Loan) Credit Default Swaps, Limits to Arbitrage

JEL Classification: L13, L14, L16, G01, G13, G14, G33