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Sovereign Debt and Credit Default Swaps

Gaston Chaumont (), Grey Gordon, Bruno Sultanum and Elliot Tobin
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No 23-05, Working Paper from Federal Reserve Bank of Richmond

Abstract: ow do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct effects feedback into default decisions. Our novel identification strategy exploits confidential microdata to quantify the extent of trading frictions and risk-sharing. The model generates realistic CDS-bond basis deviations, bid/ask spreads, and CDS volumes and positions. Our baseline specification predicts large effects of frictions generally but small spillovers from a naked CDS ban. These predictions hinge crucially on the identified parameters.

Keywords: sovereign debt; CDS; Directed search; Over-the-counter (search for similar items in EconPapers)
JEL-codes: F34 G12 (search for similar items in EconPapers)
Pages: 59
Date: 2023-03-14
New Economics Papers: this item is included in nep-dge and nep-opm
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DOI: 10.21144/wp23-05

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