Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets
Review of Financial Studies, 2015, 28(12):3303-3337
56 Pages Posted: 20 Nov 2013 Last revised: 7 Nov 2015
Date Written: July 13, 2015
We provide a model of non-redundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: It crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs.
Keywords: Credit Default Swaps, Bonds, Trading Costs, Liquidity , Bond yield, CDS-bond basis, Non-redundant derivatives
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