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

Martin Oehmke*, Adam Zawadowski

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

Abstract (may include machine translation)

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.

Original languageEnglish
Pages (from-to)3303-3337
Number of pages35
JournalReview of Financial Studies
Volume28
Issue number12
DOIs
StatePublished - 1 Dec 2015
Externally publishedYes

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