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The use of credit default swaps by bond mutual funds: Liquidity provision and counterparty risk

George O. Aragon, Lei Li and Qian, Jun ‘qj’

Journal of Financial Economics, 2019, vol. 131, issue 1, 168-185

Abstract: Corporate bond mutual funds increased their selling of credit protection in the credit default swaps (CDS) market during the 2007–2008 financial crisis. This trading activity was primarily in multi-name CDS, greater among larger and established funds, and directed toward counterparty dealers in financial distress. Funds that sold credit protection during the crisis experienced greater credit market risk and superior post-crisis performance, consistent with higher expected returns from liquidity provision. Funds using Lehman Brothers as a counterparty experienced abnormal outflows and returns of –2% immediately following Lehman's bankruptcy, suggesting that funds’ opportunistic trading in CDS exposed investors to counterparty risk.

Keywords: Bond funds; Credit default swaps; Crisis; Liquidity provision; Counterparty risk (search for similar items in EconPapers)
JEL-codes: G11 G12 (search for similar items in EconPapers)
Date: 2019
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Handle: RePEc:eee:jfinec:v:131:y:2019:i:1:p:168-185