Endogenous Trading in Credit Default Swaps
31 Pages Posted: 14 Jul 2016
Date Written: June 22, 2016
We introduce a real options model in order to quantify the moral hazard impact of credit default swap (CDS) positions on the corporate default probabilities. Moral hazard is widely addressed in the insurance literature, where the insured agent may become less cautious about preventing the risk from occurring.
Importantly, with CDS the moral hazard problem may be magnified since one can buy multiple protections for the same bond.
To illustrate this issue, we consider a firm with the possibility of switching from an investment to another one. An investor can influence the strategic decisions of the firm and can also trade CDS written on the firm. We analyze how the decisions of the investor influence the firm value when he is allowed to trade credit default contracts on the firm's debt. Our model involves a time-dependent optimal stopping problem, which we study analytically and numerically - using the Longstaff-Schwartz algorithm.
We identify the situations where the investor exercises the switching option with a loss and we measure the impact on the firm's value and firm's default probability. Contrary to the common intuition, the investor’s optimal behavior does not systematically consist in buying CDSs and increase the default probabilities. Instead, large indifference zones exists, where no arbitrage profits can be realized. As the number of the CDSs in the position increases to exceed several times the level of a complete insurance, we enter in the zone where arbitrage profits can be made. These are obtained by implementing very aggressive strategies (i.e., increasing substantially the default probability by producing losses to the firm). The profits increase sharply as we exit the indifference zone.
Keywords: CDS, moral hazard, real options, switching option, default risk, optimal stopping problems, Longstaff-Schwarz algorithm
JEL Classification: C610, G130, G33
Suggested Citation: Suggested Citation