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Credit Derivatives: Capital Requirements and Strategic Contracting

Antonio Nicolo' () and Loriana Pelizzon ()
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Antonio Nicolo': University of Padua

Authors registered in the RePEc Author Service: Antonio Nicolo' ()

No 6, "Marco Fanno" Working Papers from Dipartimento di Scienze Economiche "Marco Fanno"

Abstract: In this paper we investigate the problem of a bank, which, due to the presence of capital requirements, needs to issue credit derivatives. Because of asymmetric information in the loan and credit risk transfer markets, banks face an adverse selection problem, sharpened by the fact that credit derivative contracts are not publicly observable. We show that high-quality banks can use CDO contracts to signal their own type, even when credit derivatives are private contracts. Also a menu of contracts with a first-to-default basket and a credit default swap conditioned to the default of the first asset, can be used as a signalling device. Moreover, this last menu of contracts generates larger profits for high-quality banks than the CDO contract if the cost of capital and the loan interest rates are su¢ ciently high.

JEL-codes: G21 D82 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2005-10
New Economics Papers: this item is included in nep-fin and nep-fmk
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