A Theory of Liquidity Spillover Between Bond and CDS Markets

55 Pages Posted: 6 Mar 2014 Last revised: 13 Oct 2018

See all articles by Batchimeg Sambalaibat

Batchimeg Sambalaibat

Indiana University, Kelley School of Business

Date Written: January 13, 2018

Abstract

I build a dynamic search model of bond and CDS markets and show that allowing short positions through CDS contracts increases liquidity of the underlying bond market. This result contrasts with existing theories on derivatives, which show that derivatives fragment traders across the derivative and underlying markets and thereby decrease liquidity in the underlying cash market. I reach the opposite conclusion by endogenizing the aggregate number of investors. My results help explain how sovereign bond markets reacted to a naked CDS ban.

Keywords: credit default swaps, sovereign bonds, funding liquidity, search frictions, over-the-counter markets, credit risk

JEL Classification: F30, G1, G23

Suggested Citation

Sambalaibat, Batchimeg, A Theory of Liquidity Spillover Between Bond and CDS Markets (January 13, 2018). Available at SSRN: https://ssrn.com/abstract=2404512 or http://dx.doi.org/10.2139/ssrn.2404512

Batchimeg Sambalaibat (Contact Author)

Indiana University, Kelley School of Business ( email )

1309 E 10th St
Bloomington, IN 47405
United States

HOME PAGE: http://https://sites.google.com/site/sambalaibat/

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