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

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  • Martin Oehmke
  • Adam Zawadowski

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.

Suggested Citation

  • Martin Oehmke & Adam Zawadowski, 2015. "Synthetic or Real? The Equilibrium Effects of Credit Default Swaps on Bond Markets," The Review of Financial Studies, Society for Financial Studies, vol. 28(12), pages 3303-3337.
    • Handle: RePEc:oup:rfinst:v:28:y:2015:i:12:p:3303-3337.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhv047
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