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 have lower trading costs 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 trading-cost difference between bond and CDS. 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, January 2015.