A Theory of Liquidity Spillover Between Bond and CDS Markets

Review of Financial Studies (Forthcoming)

58 Pages Posted: 6 Mar 2014 Last revised: 12 Aug 2021

Date Written: January 13, 2018


I build a search model of bond and credit default swap (CDS) markets with endogenous investor participation and show that shorting bonds through CDS increases the liquidity and price of bonds. By allowing investors to trade the credit risk of bonds without trading the bonds, CDS introduction expands the set of feasible trades and attracts investors into the credit market. Because search is non-directed within the credit market, new investors also trade bonds and consequently increase their price and liquidity. My results suggest that naked CDS bans increased sovereigns' borrowing costs and thereby exacerbated the 2010--2012 European debt crisis.

Keywords: credit default swaps (CDS), search frictions, over-the-counter (OTC) markets, market liquidity, costly participation, CDS-bond basis, short-selling, credit risk

JEL Classification: F30, G1, G23

Suggested Citation

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

Batchimeg Sambalaibat (Contact Author)

Princeton University ( email )

Princeton, NJ

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