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

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  • Oehmke, Martin
  • Zawadowski, Adam

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

  • Oehmke, Martin & Zawadowski, Adam, 2015. "Synthetic or real? The equilibrium effects of credit default swaps on bond markets," LSE Research Online Documents on Economics 84511, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:84511
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    References listed on IDEAS

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    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance

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