Synthetic or real? The equilibrium effects of credit default swaps on bond markets

Martin Oehmke and Adam Zawadowski

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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.

JEL-codes: F3 G3 (search for similar items in EconPapers)
Date: 2015-12
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Citations: View citations in EconPapers (32)

Published in Review of Financial Studies, December, 2015, 28(12), pp. 3303-3337. ISSN: 0893-9454

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