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 existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs.
Source: Review of Financial Studies
Oehmke, Martin, and Adam Zawadowski. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets." Review of Financial Studies (forthcoming).