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

Martin Oehmke and Adam Zawadowski

The Review of Financial Studies, 2015, vol. 28, issue 12, 3303-3337

Abstract: We provide a model of nonredundant 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.

Date: 2015
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