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 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. Our framework characterizes conditions under which CDS introduction raises bond prices. The model also 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.

Source: Review of Financial Studies
Exact Citation:
Oehmke, Martin, and Adam Zawadowski. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets." Review of Financial Studies (forthcoming).
Date: 5 2015