A Theory of Liquidity Spillover Between Bond and CDS Markets
55 Pages Posted: 6 Mar 2014 Last revised: 13 Oct 2018
Date Written: January 13, 2018
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: Suggested Citation