Martin Oehmke

Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets

Coauthor(s): Adam Zawadowski.

Abstract:
We develop a model in which credit default swaps (CDSs) are non-redundant securities, based on the empirical observation that they are more liquid than the underlying reference bonds. The introduction of a CDS has an ambiguous effect on the price of the underlying bond: The CDS market (i) crowds out long bond investors with relatively frequent trading needs, (ii) reduces short selling of the bond, and (iii) leads to the endogenous emergence of basis traders who take levered hedged positions in the bond and the CDS. The model generates testable predictions on the effects of CDS introduction on bond prices, turnover in bond and CDS markets, and the CDS-bond basis. The model can also be used to assess policy interventions: e.g., a ban on naked CDSs may raise the issuer's borrowing costs.

Exact Citation:
Oehmke, Martin, and Adam Zawadowski. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets." Columbia Business School, February 2014.
Date: 2 2014