Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets
Coauthor(s): Adam Zawadowski.
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We provide a model of non-redundant credit default swaps (CDSs), building on the observation that CDSs are more liquid than bonds. CDS introduction involves a trade-off: It crowds out demand for the bond, but improves the bond allocation because it allows long-term investors to become levered basis traders. CDS introduction raises bond prices only when there is a significant liquidity difference between bond and CDS (both across and within fims). Our framework predicts a negative CDS-bond basis, turnover and price impact patterns that are consistent with empirical evidence, and shows that a ban on naked CDSs can raise borrowing costs.
Oehmke, Martin, and Adam Zawadowski. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets." Columbia Business School, June 2014.