Price Discovery in the Credit Markets

21 Pages Posted: 8 Dec 2017 Last revised: 11 Dec 2017

See all articles by Andrey D. Pavlov

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area

Eduardo S. Schwartz

Simon Fraser University (SFU); University of California, Los Angeles (UCLA) - Finance Area; National Bureau of Economic Research (NBER)

Susan M. Wachter

University of Pennsylvania - Wharton School, Department of Real Estate ; University of Pennsylvania - Finance Department

Date Written: December 4, 2017

Abstract

We derive the optimal credit default swap premium a financial institution requires to assume the default risk of fixed income instruments. This premium is a function of the institution’s capital and current exposure. In most cases, an institution requires an increasing premium to assume additional risk. However, we show that an under-capitalized institution that already has substantial default risk exposure would engage in risk-shifting and assume more risk at lower rates. In other words, the presence of a financial institution with large default risk exposure in the market reduces the premium required to insure additional risk. Therefore, negative signals about the default risk of the debt instruments may vastly increases the quantity of insured instruments with no effect on insurance premium. In fact, default insurance premiums decline in the face of increasing demand. Consistent with this, prior to the recent financial crisis, the credit default swap issuance increased greatly, as did the volume of the underlying nontraditional mortgages, but the data suggests that required premiums stayed constant or declined.

Keywords: Credit Insurance, Credit Default Swaps, Price Discovery

Suggested Citation

Pavlov, Andrey D. and Schwartz, Eduardo S. and Wachter, Susan M., Price Discovery in the Credit Markets (December 4, 2017). Available at SSRN: https://ssrn.com/abstract=3082431 or http://dx.doi.org/10.2139/ssrn.3082431

Andrey D. Pavlov

Simon Fraser University (SFU) - Finance Area ( email )

Burnaby, British Columbia V5A 1S6
Canada
604 291 5835 (Phone)
604 291 4920 (Fax)

Eduardo S. Schwartz

Simon Fraser University (SFU) ( email )

8888 University Drive
Burnaby, British Columbia V5A 1S6
Canada

University of California, Los Angeles (UCLA) - Finance Area ( email )

Los Angeles, CA 90095-1481
United States
310-825-1953 (Phone)
310-206-5455 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Susan M. Wachter (Contact Author)

University of Pennsylvania - Wharton School, Department of Real Estate ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104-6330
United States
215-898-6355 (Phone)

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

HOME PAGE: http://real.wharton.upenn.edu/~wachter/index.html

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