Martin Oehmke

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

Coauthor(s): Adam Zawadowski.

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Abstract:
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.

Exact Citation:
Oehmke, Martin, and Adam Zawadowski. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets." Columbia Business School, June 2014.
Date: 6 2014