Abstract not found

The misalignment of corporate bond and credit default swap spreads (the CDS-bond basis) during the 2008 financial crisis is often attributed to corporate bond dealers ’ shed-ding inventory when liquidity was scarce. This paper documents evidence against this widespread perception. In the months following Lehman’s collapse, dealers, including pro-prietary trading desks in investment banks, provided liquidity in response to major selling activity on the part of clients. The dealers ’ corporate bond inventories rose sharply as a result. Although providing liquidity, dealers did not trade aggressively enough to close the CDS-bond basis. We also show that declining corporate bond prices following Lehman’s collapse were concentrated in bonds with available CDS contracts and high levels of ac-tivity in basis trades, indicating that the presence of derivative contracts can disrupt the underlying cash market. Overall, our results suggest that the unwinding of CDS-bond basis trades by non-dealer arbitrageurs including hedge funds was the main cause of the large negative basis and the disruption of the credit market.

I build a search model of bond and CDS markets that features en-dogenous funding liquidity and interdependent bond and CDS market liquidity. I show that, in the long run, speculative CDS purchases at-tract greater funding liquidity into credit markets that then, due to search frictions, spills over and increases bond market liquidity. In the short-run, however, the aggregate capital invested in credit markets remains fixed and, as a result, speculative CDS purchases attract liq-uidity away from the bond market. The opposite short- and long-run effects help explain the observed effects of speculative CDS bans on liquidity of the underlying bond markets. A large body of work explores, in the context of exchange traded assets, why financial derivatives exist and how they affect the underlying assets. A majority of asset classes, however, are traded over-the-counter (OTC).1 In the last decade, a significant research has emerged on liquidity and search frictions in OTC markets. Despite the insights from this literature, our understanding of the effects of derivatives is limited in the context of OTC

Credit default swaps (CDS) have been growing in importance in the global finan-cial markets. However, their role has been hotly debated, in industry and academia, particularly after the credit crisis of 2008-2009 and the European sovereign crisis of 2010-2012. We review the extant literature on CDS that has accumulated over the past two decades. We divide our survey into seven topics after providing a broad overview in the introduction. The second section traces the historical development of CDS markets and provides an introduction to CDS contract definitions and con-ventions. The third section discusses the pricing of CDS, from the perspective of no-arbitrage principles as well as from that of structural and reduced-form credit risk models. It also summarizes the literature on the determinants of CDS spreads, with a focus on the role of fundamental credit risk factors, liquidity and counterparty risk. The fourth section discusses how the development of the CDS market has af-fected the characteristics of the related bond and equity markets, with an emphasis

The introduction of credit default swaps (CDS) trading on an underlying firm may influence its future access to external financing and, hence, its precautionary demand for cash. In this paper, we empirically estimate this effect of CDS trading, using a comprehensive sample of North American corporate CDS introductions between 1997 and 2009. We show that corporate cash holdings, as a proportion of assets, increase after the inception of CDS trading. This impact is significant, even after controlling for the potential endogeneity of CDS trading. We also find that the increase in the cash-to-assets ratio is greater for firms with relatively large amounts of CDS contracts outstanding, and those with more limited access to financial markets. Moreover, the impact of CDS trading goes beyond the direct effects of bank lines of credit, which are generally less reliable sources of finance.

We examine the effect of introducing Credit Default Swaps (CDSs) on firms’ investment and financing policies. Our model allows for dynamic investment and dynamic financing using equity and debt, and credit risk can be hedged using CDSs. A calibrated version of the model allows us to do a counterfactual analysis, in which we compare an economy with to an economy without a CDS market. Both the negative effect of CDSs of increasing the probability of bankruptcy and the positive effect of reducing the risk of strategic default are present in the model. The effect of reducing the cost of debt dominates, allowing the firm to gain from a source of financing less costly than equity, which leads to higher investment and firm value. Our model is able to reconcile seemingly conflicting empirical evidence regarding the effect of CDSs in reducing the cost of debt capital and in increasing the default probability. Finally, we show that the real effect on investment and firm value is largest for firms that are small and have high growth opportunities.

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Strategic conduct in credit derivative marke ates tates sear Th re n pro d s es in financial markets during 007–09 was the creation and e market for credit insurance, m rela S mark notion ceeded e part ew net entiall ance contract, a fundamental difference between a CDS and a traditional insurance contract is that a CDS offers a payment from the protection seller to the protection buyer even when the buyer is not a holder of

During the recent debt crisis in Europe, policy makers responded to the controversy surrounding CDS by implementing a series of policies that banned CDS trading. I use these bans as quasi-natural experiments to identify how derivative markets affect liquidity of the underlying cash market. I document that a temporary CDS ban increased bond market liquidity but a permanent ban instead decreased bond market liquidity. To explain these patterns, I build a dynamic search-theoretic model of over-the-counter bond and CDS markets that features an endogenous liquidity interaction between the two markets. My model shows that these opposing patterns are due to the fact that bond and CDS markets are substitute markets in the short run but are complementary markets in the long run. My results challenge existing theories of liquidity interaction among multiple markets and the common perception that the CDS market is a more liquid market than the bond market. Are financial derivatives just redundant securities or do they affect the un-derlying asset, and in what ways? The recent crises in the US and in Europe and the policy debate surrounding these events illustrated our limited un-derstanding of the recent financial innovations and derivatives such as credit derivatives and securitization. In this paper, I study both empirically and theoretically how derivatives affect price and liquidity of the underlying as-set in a particular context: sovereign bond and credit default swap (CDS) markets.1 The controversy surrounding CDS during the debt crisis in Eu-rope culminated in a series of policies that banned “naked ” purchases of CDS