Article

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

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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.

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... This last result tends to be hard to obtain because it indicates CDS are expensive relative to bonds, which normally can be arbitraged away by selling CDS protection and buying bonds (a trade permitted by the benchmark's portfolio restrictions). For instance, Oehmke and Zawadowski (2015) prove in their corporate CDS model the basis must be negative (Proposition 4). We show the model delivers a positive basis through higher gains from trade leading to higher matching probabilities. ...
... Most of this literature focuses on outcomes of a single asset market, but some recent work investigates interactions between multiple assets. This is the case for recent work by Oehmke and Zawadowski (2015) and even more closely related work by Sambalaibat (2022). 3 Oehmke and Zawadowski (2015) characterize the interactions between corporate bonds and CDS and propose a theory where corporate CDS are not redundant because they are cheaper to trade. ...
... This is the case for recent work by Oehmke and Zawadowski (2015) and even more closely related work by Sambalaibat (2022). 3 Oehmke and Zawadowski (2015) characterize the interactions between corporate bonds and CDS and propose a theory where corporate CDS are not redundant because they are cheaper to trade. This assumption does not necessarily carry over to the sovereign CDS market, and we show how to identify the costs from the data. ...
... We provide evidence supporting recent research highlighting CDS as a nonredundant security. In particular, the CDS market is argued to provide an important economic function through the standardized nature of the CDS contract, which leads the CDS to have lower trading costs and greater liquidity than the cash bond and makes the CDS market the preferred trading venue for speculators and the leader in price discovery (Das, Kalimipalli and Nayak 2014;Oehmke andZawadowski 2015, 2016). Consistent with this view, we show that the information contained in past performance of the CDS is superior to that of the bond. ...
... We provide evidence supporting recent research highlighting CDS as a nonredundant security. In particular, the CDS market is argued to provide an important economic function through the standardized nature of the CDS contract, which leads the CDS to have lower trading costs and greater liquidity than the cash bond and makes the CDS market the preferred trading venue for speculators and the leader in price discovery (Das, Kalimipalli and Nayak 2014;Oehmke andZawadowski 2015, 2016). Consistent with this view, we show that the information contained in past performance of the CDS is superior to that of the bond. ...
... That is, removing firms that undergo future rating changes entirely eliminates (the already much weaker) bond momentum profits for CDS-matched firms but minimally affects bond momentum profits for non-CDS-matched firms. Furthermore, even within the cross-section of CDS-matched firms, we show that firm-level impediments to arbitrage, such as fragmentation of bond issues (Oehmke and Zawadowski 2016), weaken the link and exacerbate the disconnect between the momentum effects in the two markets. ...
Article
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This paper highlights the adverse consequences of sluggish credit rating updates in creating information efficiency distortions and investment anomalies. We first document significant credit default swap (CDS) return momentum yielding 7.1% per year. We further show that cross-market momentum strategies based on information in past CDS performance generates an alpha of 10.3% per year in stocks and 7.3% per year in bonds. These CDS momentum and cross-market effects are stronger among more liquid, informationally rich CDS contracts whose CDS spreads move in anticipation of important, yet slow-moving, credit rating changes. (JEL G12, G14) Received February 19, 2020; editorial decision July 10, 2020 by Editor Jeffrey Pontiff. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.
... On the theoretical side, for example, Garleanu and Pedersen (2011) study the CDS-bond basis using a relative pricing framework allowing the derivatives to have a lower margin than the underlying assets. Oehmke and Zawadowski (2015)'s key insights for their endogenous negative CDS-bond basis focus on the differential transaction costs in the corporate bond and CDS markets. ...
... Also, more importantly, we focus on how the firm-level disagreement is linked with the aggregate level of macro uncertainty through informational friction betas. Such effect on the cross-sectional variation of CDS-bond bases is not considered in Oehmke and Zawadowski (2015). ...
... This is likely due to the constant improvements in liquidity and informational efficiency in the CDS market comparing to the bond market. 10 The widening effect of the informational friction on the negative basis is consistent with Oehmke and Zawadowski (2015) who show in their static model that increasing uncertainty about firm's credit risk reduces the mass of investors with moderate beliefs who pursue basis trading, therefore widens the negative CDS-bond basis. While Oehmke and Zawadowski (2015)'s model can only reproduce negative basis, our dynamic model can accommodate both positive and negative bases. ...
Preprint
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We study how macroeconomic uncertainty (EU) manifests into the cross-sectional variations of the credit default swap (CDS)-bond bases. We develop a structural model in which common EU induces informational friction affecting the pricing in the bond and CDS markets. Higher EU will lead to a larger cross-sectional divergence in the bases. Furthermore, the difference between the two markets' exposure to EU measured by the EU betas can predict cross-sectional variations in the bases, which is confirmed in our empirical study. We also study the practical implication of EU as a new basis determinant in the context of the basis arbitrage.
... Therefore, the inception of CDS markets should not have an impact on corporate bond markets. However, various studies predict a crowding-out effect, i.e. a migration of long and short bond investors to the more liquid CDS market (see, e.g., Che and Sethi, 2014;Oehmke and Zawadowski, 2015). Sambalaibat (2018) challenges this view and shows that the presence of CDS markets leads to a liquidity spillover effect: a greater number of bond buyers and larger bond trading volumes. ...
... However, the authors also predict that naked CDS positions can induce optimistic investors to divert their capital away from purchasing corporate bonds and towards selling CDS protection. Oehmke and Zawadowski (2015) also underline the ambiguous effect of CDS introduction on the underlying bond market. On the one hand, the migration of long and short bond investors to the CDS market reduces demand for corporate bonds (crowding-out effect). ...
... My paper provides direct empirical evidence for this liquidity spillover effect. With regard to the model of Oehmke and Zawadowski (2015), I show that the increased demand from basis traders dominates the crowding-out effect. ...
Article
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Using regulatory data on CDS holdings and corporate bond transactions, I provide evidence for a liquidity spillover effect from CDS to bond markets. Bond trading volumes are larger for investors with CDS positions written on the debt issuer, in particular around rating downgrades. I use a quasi-natural experiment to validate these findings. I also provide causal evidence that CDS mark-to-market losses lead to fire sales in the bond market. I instrument for the prevalence of mark-to-market losses with the fraction of non-centrally cleared CDS contracts of an individual counterparty. The monthly corporate bond sell volumes of investors exposed to large mark-to-market losses are three times higher than those of unexposed counterparties. Returns decrease by more than 100 bps for bonds sold by exposed investors, compared to same-issuer bonds sold by unexposed investors. My findings underline the risk of a liquidity spiral in the credit market.
... Oehmke and Zawadowski (2014a) study the determinants of corporate CDS trading volume and net open interest and conclude that corporate CDS markets emerge as alternative trading venues for hedging and speculation, partially as a result of bond market fragmentation, a prediction made in Oehmke and Zawadowski (2014b). Our research is complementary to their work since we focus on the sovereign CDS market and attempt to answer similar questions. ...
... Thus, we need to be careful in selecting the variables for such a regression. To the extent possible, we investigate determinants that are theoretically motivated for trading in corporate credit default insurance (Oehmke and Zawadowski, 2014b). We also examine several country-specific characteristics that could potentially explain traded quantities based on economic intuition. ...
... To capture potential non-linearities, and, motivated by the importance of volatility in structural credit risk models, we also include a proxy for countryspecific credit risk volatility, computed as the quarterly sum of the daily squared percentage changes in CDS spreads. In addition, since market participation may depend on the underlying liquidity of the CDS market (Oehmke and Zawadowski, 2014b;Sambalaibat, 2013), we proxy for it by using CDS depth, i.e., the number of dealer quotes used in the computation of the mid-market spread (Qiu and Yu, 2012). ...
Article
We provide a comprehensive analysis of the determinants of trading in the sovereign credit default swaps (CDS) market, using weekly data for single-name sovereign CDS from October 2008 to September 2015. We describe the anatomy of the sovereign CDS market, derive a law of motion for gross positions and their components, and identify the key factors that drive the cross-sectional and time-series properties of trading volume and net notional amounts outstanding. While a single principal component accounts for 54 percent of the variation in sovereign CDS spreads, the largest common factor explains only 7 percent of the variation in sovereign CDS net notional amounts outstanding. Moreover, unlike for CDS spreads, common global factors explain very little of the variation in sovereign CDS trading and net notional amounts outstanding, suggesting that it is driven primarily by idiosyncratic country risk. We analyze several local and regional channels that may explain the trading in sovereign CDS: (a) country-specific credit risk shocks, including changes in a country's credit rating and related outlook changes, (b) the announcement and issuance of domestic and international debt, (c) macroeconomic sentiment derived from conventional and unconventional monetary policy, macro-economic news and shocks, and (d) regulatory channels, such as changes in bank capital adequacy requirements. All our findings suggest that sovereign CDS are more likely used for hedging than for speculative purposes.
... This situation gives rise to the so-called negative basis trade, in which a trader purchases the bond and buys CDS protection to exploit the relative price difference between the bond and CDS markets. Consistent with the predictions of the equilibrium model of Oehmke and Zawadowski (2015), we show that CDS positions are increasing in the negative basis. This result suggests that arbitrageurs use CDSs to lean against the negative CDSbond basis. ...
... Note that, whereas hedging demand is naturally related to insurable interest, there is no reason to believe that speculative trading activity (i.e., bets on future changes in credit quality) in the CDS market should be directly related to insurable interest. 2 More broadly, our paper relates to a growing literature that investigates the effects of CDS markets on information transmission, risk transfer, and credit market outcomes (Acharya and Johnson 2007;Qiu and Yu 2012;Minton, Stulz, and Williamson 2009;Ashcraft and Santos 2009;Hirtle 2009;Saretto and Tookes 2013), as well as a growing theory literature on the uses of CDSs (Duffee and Zhou 2001;Parlour and Plantin 2008;Thompson 2009;Parlour and Winton 2013;Bolton and Oehmke 2011;Zawadowski 2013;Atkeson, Eisfeldt, and Weill 2015;Che and Sethi 2014;Fostel and Geanakoplos 2012;Oehmke and Zawadowski 2015). Du and Zhu (2013), Gupta and Sundaram (2012), and Chernov, Gorbenko, and Makarov (2013) investigate CDS settlement auctions. ...
... For example, if insuring the bond in the CDS market is cheap relative to the default premium offered by the bond (a negative basis), arbitrageurs will enter a negative basis trade in which they purchase the bond and CDS protection, thereby increasing the amount of outstanding CDSs. Here, we base our hypotheses on the theoretical framework of Oehmke and Zawadowski (2015), who show that in equilibrium such arbitrage trades lead to a positive correlation between a more negative CDS-bond basis (due to bond illiquidity or bond supply shocks) and the size of CDS positions taken by arbitrageurs. Their model also predicts that stronger arbitrage activity influences economic outcomes, by compressing the CDS-bond basis and reducing price impact in the bond market. ...
Article
Using novel position and trading data for single-name corporate credit default swaps (CDSs), we provide evidence that CDS markets emerge as “alternative trading venues” serving a standardization and liquidity role. CDS positions and trading volume are larger for firms with bonds fragmented into many separate issues and with heterogeneous contractual terms. Whereas hedging motives are associated with trading volume in the bond and CDS markets, speculative trading concentrates in the CDS. Cross-market arbitrage links the CDS and bond market via the basis trade, compressing the negative CDS-bond basis and reducing price impact in the bond market. Received September 24, 2014; accepted January 17, 2016 by Editor Andrew Karolyi.
... This situation gives rise to the so-called negative basis trade, in which a trader purchases the bond and buys CDS protection to exploit the relative price difference between the bond and CDS markets. Consistent with the predictions of the equilibrium model of Oehmke and Zawadowski (2015), we show that CDS positions are increasing in the negative basis. This result suggests that arbitrageurs use CDSs to lean against the negative CDSbond basis. ...
... For example, if insuring the bond in the CDS market is cheap relative to the default premium offered by the bond (a negative basis), arbitrageurs will enter a negative basis trade in which they purchase the bond and CDS protection, thereby increasing the amount of outstanding CDSs. Here, we base our hypotheses on the theoretical framework of Oehmke and Zawadowski (2015), who show that in equilibrium such arbitrage trades lead to a positive correlation between a more negative CDS-bond basis (due to bond illiquidity or bond supply shocks) and the size of CDS positions taken by arbitrageurs. Their model also predicts that stronger arbitrage activity influences economic outcomes, by compressing the CDS-bond basis and reducing price impact in the bond market. ...
... Moreover, to the extent that arbitrage activity is present, it may have economic consequences. Consistent with the theoretical predictions of Oehmke and Zawadowski (2015), our evidence shows that more arbitrage activity helps eliminate relative mispricing between the bond and the CDS and, by facilitating the absorption of bond supply shocks, is associated with lower price impact in the bond market. ...
Article
Using novel position and trading data for single-name corporate credit default swaps (CDSs), we provide evidence that CDS markets emerge as "alternative trading venues" that serve a standardization and liquidity role. CDS positions and trading volume are larger for firms with bonds that are fragmented into many separate issues and have heterogeneous contractual terms. Whereas hedging motives are associated with trading volume in the bond and CDS markets, speculative trading concentrates in the CDS. Cross-market arbitrage links the CDS and bond market via the basis trade, impressing the negative CDS-bond basis and reducing price impact in the bond market.
... Second, we show that the basis between two assets depends not only on the margin requirements of the assets themselves but also on the margin requirements for derivative debt contracts collateralized by the assets. Relatedly, Oehmke and Zawadowski (2015) show that a negative basis emerges when transaction costs are higher for bonds than for CDS. In our paper, negative bases can persist when risky assets are imperfect collateral, and positive bases can persist even when agents can short assets because the efficient use of collateral is to buy CDS rather than to short assets. ...
... The second part of this corollary is particularly important because it links to the literature on liquidity and CDS trading (e.g., Oehmke and Zawadowski 2015). This model provides a novel explanation for how CDS inclusion into structured finance products affects liquidity. ...
Article
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We consider a multi-state, general-equilibrium model with collateralized financial promises to study how allowing an asset to back multiple financial contracts (i.e., tranching) affects price bases. A basis emerges when one asset can be tranched to issue more derivative securities than can be backed by another asset. Variations in the ability to tranche an asset or to pyramid derivative debt lead to variations in price bases. Tranching a CDS, as occurs with the CDX index, increases the basis on the underlying asset. Our theory correctly predicts that inclusion in the CDX index increases the underlying CDS basis.
... This mechanism allows the market participants to estimate the credit risk about the health of the underlying. It turns out that CDS trading reduce the transaction cost, offers liquidity to the market, and affect the underlying significantly, see (Oehmke and Zawadowski 2015). ...
... That is, main CDS trading should be cleared through central counterparties to improve the transparency of the credit market. Another reform in the EU is to ban the short selling of the naked position of sovereign CDS, partially because of the concerns about the liquidity risk from CDS trading, despite that the borrowing costs may increase significantly (Calice, Chen, and Williams 2013;Oehmke and Zawadowski 2015). ...
Article
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The diversified strategy can reduce the systematic risk efficiently, but may fail to account for emergent and default risk that many decision-makers usually face at large-scale level. Modern data-driven methodologies allow optimizing both systematic and non-systematic risks in a unified framework. In this article, we demonstrate an approach to analyze and compare partial-diversified portfolios of Credit Default Swap. We classify and investigate different metrics of credit risks and integrate them with limited diversification and other performance objectives. We test the developed approach in a study of hundreds of business contract investments over the recent financial crisis. The results indicate that the decisions using limited diversification are more robust in terms of allocation structure and out-of-sample downside risks reduction. Therefore, the partial-diversified optimization models provide alternatives to support a variety of problems involving unknown risks.
... • The notional amounts of both increases have a difference of less than or equal to 26 See for example Garleanu and Pedersen (2011), Oehmke and Zawadowski (2016), Oehmke and Zawadowski (2015), Fontana (2011) and Bai and Collin-Dufresne (2011). ...
... The authors attribute the evidence to the costs and benefits of team management including more expertise, experience and skills but more coordination problems and longer decision times. Jiang and Zhu (2015) essentially test and confirm the theory of Oehmke and Zawadowski (2015) on the liquidity provision role of the CDS market. They additionally argue that smaller funds follow leading funds in risk taking and mutual funds use CDS also for yield chasing purposes since the average spread of funds' CDS positions is higher than that of their rest of the portfolio. ...
Thesis
Die vorliegende Dissertation besteht aus drei Kapiteln über die Investmentfonds. Das erste Kapitel befasst sich mit der Rolle der Fondsmanager in der Bilanzverschönerung. Auf Basis der Analyse der Karrierewege von amerikanischen Fondsmanagern werden signifikante zusammenwirkende Manager-Fixed-Effects identifiziert, die nach der Kontrolle der endogenen Matching-Probleme immer noch robust sind. Die geschätzten Manager-Fixed-Effects haben signifikante Einflüsse auf die Out-of-Sample-Vorhersagen. Außerdem wird festgestellt, dass die Verriegelungen der Investmentfonds, die von gemeinsamen Managern verwaltet wurden, wichtige Kanäle für die Bilanzverschönerung verursachen. Das zweite Kapitel beschäftigt sich mit den Investmentstrategien der Fonds im Hinblick auf die Nutzung von Credit Default Swaps (CDS). Die Zuordnung der CDS-Positionen der Investmentfonds zu ihrem Bestandportfolio bietet eine neue Methodik zur Identifizierung der CDS-Strategien und kompensiert somit die Analysen der existierenden Literatur auf der Makroebene. Die Ergebnisse zeigen, dass die Anreize zur Risikoreduzierung die Spekulationsanreize dominieren, insbesondere, wenn die Kreditexposition durch ungedeckte Leerverkäufe der CDS-Verträge erhöht wird. Die erfahrenen Fondsmanager tendieren dazu, mehr Kreditrisiko in Kauf zu nehmen, während es für die Fondsmanagerinnen wahrscheinlicher als für ihre männlichen Kollegen ist, gegen das bestehende Risiko abzusichern. Der letzte Teil nimmt die Pleite von Lehman Brothers unter die Lupe, um sich mit der daraus resultierenden unerwarteten Schließung der CDS-Positionen als einem natürlichen Experiment auseinanderzusetzten. Diese Studie dient zur Untersuchung der Risiko- und Leistungsimplikationen der CDS-Investments der Fonds. Die Investmentfonds besitzen bei ihren CDS-Transaktionen im Durchschnitt einen beachtlichen Teil Extremrisiko. Während die CDS-Nutzer von guten Gesamtmarktlagen profitieren, erleiden sie unter Verlusten bei geclusterten Ausfällen.
... Das, Kalimipalli, and Nayak (2014) document that the corporate bond market becomes more inefficient once CDS trading commences. Oehmke and Zawadowski (2015) show theoretically that, during times of tough financing conditions for basis traders, the basis can turn significantly negative, consistent with our findings. ...
... The second measure for basis arbitrage, BasisArb2, is based on Zawadowski (2015, 2017). Specifically, Oehmke and Zawadowski (2017) show that the size of basis trading is proportional to the product of the magnitude of the negative basis and the strength of basis arbitrage trading given a negative basis, which is negatively related with bond issues fragmentation, the roundtrip trading cost of a bond, the TED spread, and disagreement between analyst earnings forecasts, by testing the model implications of Oehmke and Zawadowski (2015). We compute BasisArb2 as a bond-level measure of basis arbitrage activity, using the regression coefficients in Oehmke and Zawadowski (2017). ...
... The only functional form difference between (19) and (16) is the final term on the right hand side, ṗ i − d D i h 2 1−ṗ i . This term is always greater than zero becauseṗ i > d D i whenever a funding equilibrium exists. ...
... Then the right hand side of (19) is equal to zero and h 1 ṗ i (q i ) , d D i = 1 meaning there is no equilibrium funding for firm i. Suppose the lower-limiting case where d D i = 0, in which case the right hand side of (19) is strictly greater than that of (15), a contradiction. Thusṗ i <p i for ∀d D i ∈ 0, p D i . ...
Article
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This paper highlights two new effects of credit default swap (CDS) markets on credit markets. First, when firms' cash flows are correlated, CDS trading impacts the cost of capital and investment for all firms, even those that are not CDS obligors. Second, CDSs generate a tradeoff between default premiums and default risk. CDSs alter firm incentives to invest along the extensive default premium margin, even absent maturity mis-match. Firms are more likely to issue safe debt when default premiums are high and vise versa. The direction of the tradeoff depends on whether investors use CDSs for speculation or hedging.
... The only functional form difference between (19) and (16) is the final term on the right hand side, ṗ i − d D i h 2 1−ṗ i . This term is always greater than zero becauseṗ i > d D i whenever a funding equilibrium exists. ...
... Then the right hand side of (19) is equal to zero and h 1 ṗ i (q i ) , d D i = 1 meaning there is no equilibrium funding for firm i. Suppose the lower-limiting case where d D i = 0, in which case the right hand side of (19) is strictly greater than that of (15), a contradiction. Thusṗ i <p i for ∀d D i ∈ 0, p D i . ...
Article
This paper highlights two new effects of credit default swap (CDS) markets on credit markets. First, when firms' cash flows are correlated, CDS trading impacts the cost of capital and investment for all firms, even those that are not CDS obligors. Second, CDSs generate a tradeoff between default premiums and default risk. CDSs alter firm incentives to invest along the extensive default premium margin, even absent maturity mis-match. Firms are more likely to issue safe debt when default premiums are high and vise versa. The direction of the tradeoff depends on whether investors use CDSs for speculation or hedging.
... But speculative-motivated CDS trading may increase bank credit risk as well as counterparty risk and harm the stability of the financial system. Speculation is not inherently problematic and can improve market prices and liquidity, but speculation in the derivatives market is accompanied by unlimited profit and loss possibilities and can exacerbate the instability of the financial system (Bakoush et al., 2019;Duffie, 2010;Oehmke & Zawadowski, 2015;Raimbourg & Salvadè, 2021). Therefore, another main research objective of this paper is to dissect the mechanisms at work, considering the impact of the speculative behavior of CDS participants on the banking systemic risk. ...
Article
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During the U.S. subprime mortgage crisis, credit default swaps (CDS) played a pivotal role and became an influential booster. However, most studies only study the systemic risk of CDS in the interbank market and do not quantify how CDS speculation affects the systemic risk. Therefore, to study the impact of CDS speculation on the systemic risk, this paper constructs a multi-layered complex network, which includes bank-firm-CDS sellers to reproduce speculation in the CDS market. Then, the impact of different CDS speculation ratios and regulatory ratios on the banking systemic risk of a multi-layered complex network are investigated separately under different credit shocks. The results show that the systemic risk is positively correlated with the CDS speculation ratio, and that speculation adversely influences system stability, although it is profitable for some banks. Moreover, the effectiveness of the regulation is affected by the size of credit shocks, if credit shocks are large, the systemic risk is negatively related to regulatory ratios. Because the regulation system on CDS sellers limits the expansion of the CDS market, reduces the counterparty risk for banks, and makes the banking system more stable. Instead, if credit shocks are low, strict regulation has the potential to increase the systemic risk. The study provides a novel perspective on utilizing rational credit risk mitigation instruments to prevent systemic risks.
... To construct the basis, we obtain interpolated CDS premiums using the sovereign CDS data from Markit. For each bond in each period, we then subtract the bond's spread from the duration-matched CDS premium following the methodology in Oehmke and Zawadowski (2015) and Kim et al. (2016). Figure 7 plots the median CDS-bond basis as well as the interquartile ranges depicted by the shaded band between January 2003 and October 2020 for both investment-grade countries (Panel A) and speculative-grade countries (Panel B). ...
... According to Olléon Assouan (2004) and Oehmke and Zawadowski (2015), the basis evolution analysis may well present a credit risk indicator. Generally, it is null considering the theoretical equality of the two premiums except that recent studies have found that it may well deviate from the zero value specifically when following the crisis periods. ...
... Within the broader context of 'fundamentals-based' strategies, the main competitors to FS-based techniques are the so-called Market-Based Models (MBMs). ‡ Admittedly, ¶ This section is largely based on Augustin et al. (2014) and Oehmke and Zawadowski (2015) and their excellent descriptions of the CDS market, trading motives and market participants. ...
Article
To cite this article: George Chalamandaris (2020): Assessing the relevance of an information source to trading from an adaptive-markets hypothesis perspective, Quantitative Finance, I propose a framework motivated by the Adaptive Markets Hypothesis (AMH) to analyze the relevance of a specific information source for the trading of a given security. To illustrate the applicability and advantages of this methodology, I explore the extent to which the financial statement (FS) is relevant for Credit Default Swap (CDS) trading. Specifically, I adopt a Bayesian Model Averaging approach to examine properties of the accounting metrics that enter the implied trading heuristics of the market participants. Hypothesis-testing is conducted on various horizons around the announcement dates of corporate results. The diversity of trading rules and the shift in the heuristics mix that occurred after 2008 support the AMH perspective. Overall, results show that there is a significant component of profit-motivated trading in the CDS market that relies on financial statement information , even after controlling for information transmission from alternative trading forums. Out of sample trading strategies confirm the robustness the main findings.
... This evidence supports the theory ofOehmke and Zawadowski (2015) that one role of the CDS market is to transform liquidity by repackaging the default risk of an illiquid bond into a liquid derivative security (i.e., CDS).3 Aragon, Ergun, Getmansky, and Girardi (2017) measure liquidity mismatches in hedge funds using nonpublic filings of Form PF.4 Studies show that FoFs add value to their investors by providing access to diversified pools of hedge funds(Brown, Gregoriou, and Pascalau (2012)), economizing on the monitoring costs associated with due diligence(Brown, Fraser, and Liang (2008)), and firing managers ahead of poor performance(Aiken, Clifford, and Ellis (2015a)). 5 SeeAragon and Strahan (2012),Ben-David, Franzoni, and Moussawi (2012),Cao, Chen, Goetzmann, and Liang (2016),and Cao, Liang, Lo, and Petrasek (2018) for studies of hedge funds' impact on stock market efficiency.https://doi.org/10.1017/S0022109018001369 ...
Article
We examine liquidity transformation by funds of hedge funds (FoFs) by developing a new measure, illiquidity gap, that captures the mismatch between the liquidity of their portfolios and the liquidity available to their investors. We find that higher liquidity transformation is driven by FoFs’ incentives to attract more capital and earn higher compensation. Greater liquidity transformation is associated with higher exposure to investor runs and worse performance during crisis periods. Finally, FoFs mitigate the risks associated with liquidity transformation by maintaining higher cash buffers.
... Our future research will aim at understanding different aspects related to the flow-of-risk. For example, given the large decline in notional traded, we wonder i) in which part of the flow-of-risk this reduction is taking place and whether this may be due to risk-mitigation technique such as compression or central clearing, and ii) whether this is affecting individual net positions, thereby understanding the motives for engaging in these markets (Oehmke and Zawadowski, 2015a;Fontana and Scheicher, 2016). Another avenue of work, which we cannot fully carry out with our current anonymised sample, is related to measuring the extent to which risk flows are overlapped in the network. ...
Article
We develop a framework to analyse the credit default swap (CDS) market as a network of risk transfers among counterparties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation. This architecture shows three distinct sets of counterparties: (i) Ultimate Risk Sellers (URS), (ii) Dealers (indirectly connected to each other), (iii) Ultimate Risk Buyers (URB). We show that the probability of widespread distress due to counterparty risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011–2014. We find the presence of a bow-tie network architecture consistently across both reference entities and time, and that the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities.
... 34 The next candidate is a bond's liquidity. It is theoretically documented (e.g., Oehmke and Zawadowski (2015)) that the effects of CDS on bond spreads would depend on the liquidity of underlying bonds. The authors argue that illiquid bonds would benefit more than liquid bonds from the traded CDS. ...
Article
When a firm writes incomplete debt contracts, its limited ability to commit to not strategically default and renegotiate its debt requires the firm to pay higher yields to its creditors. Hedged by credit derivatives, creditors have stronger bargaining power in the case of debt renegotiation, which ex-ante demotivates the firm to default strategically. In this paper, I aim to investigate theoretically and empirically whether credit derivatives could help reduce the cost of debt contracting stemming from the possibility of strategic default. I find that firms with a priori high strategic default incentives experience a relatively large reduction in their corporate bond spreads after the introduction of credit default swaps (CDS) written on their debt. This result is robust to controlling for the endogeneity of CDS introduction. My finding is consistent with the presence of CDS reducing the strategic default-related cost of corporate debt, suggesting the beneficial role of credit derivatives as a commitment device for the borrower to repay the lender.
... The model in the Shen et al. [2014] paper analyzes the banks' choice between buying bonds, making loans, and selling CDS. Similarly, Oehmke and Zawadowski [2014a] argue that CDS contracts provide a more liquid alternative to trading the underlying bonds for institutional investors. ...
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Credit default swaps (CDS) have been growing in importance in the global financial markets. However, their role has been hotly debated, in industry and academia, particularly since the credit crisis of 2007–2009. 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 conventions. The third section discusses the pricing of CDS, from the perspective of no-arbitrage principles, 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 affected the characteristics of the bond and equity markets, with an emphasis on market efficiency, price discovery, information flow, and liquidity. Attention is also paid to the CDS-bond basis, the wedge between the pricing of the CDS and its reference bond, and the mispricing between the CDS and the equity market. The fifth section examines the effect of CDS trading on firms' credit and bankruptcy risk, and how it affects corporate financial policy, including bond issuance, capital structure, liquidity management, and corporate governance. The sixth section analyzes how CDS impact the economic incentives of financial intermediaries. The seventh section reviews the growing literature on sovereign CDS and highlights the major differences between the sovereign and corporate CDS markets. In the eight section, we discuss CDS indices, especially the role of synthetic CDS index products backed by residential mortgage-backed securities during the financial crisis. We close with our suggestions for promising future research directions on CDS contracts and markets.
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This study analyzes the motivations for and consequences of funds' credit default swap (CDS) investments using mutual funds' quarterly holdings from pre‐ to post‐financial crisis. Funds invest in CDS when facing unpredictable liquidity needs. Funds sell more in reference entities when the CDS is liquid relative to the underlying bonds and buy more when the CDS‐bond basis is more negative. To enhance yield, funds engage in negative basis trading and sell CDS with the highest spreads within rating categories, and with spreads higher than those of their bond portfolios. Funds with superior portfolio returns also demonstrate more skill in CDS trading. This article is protected by copyright. All rights reserved
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We find that a firm’s stock price reaction to its credit rating downgrade announcement is muted by 44–52% when credit default swaps (CDSs) trade on its debt. We explore the role of the CDS markets in providing information ex ante and relieving financing frictions ex post for downgraded firms. We find that the impact of CDS trading is more pronounced for firms whose debt financing is more dependent on credit ratings (e.g., those rated around the speculative-grade boundary, those with a higher number of rating-based covenants). Reductions in debt and investment, and the increase in financing costs are less severe for CDS firms than non-CDS firms following an identical credit rating downgrade. Our results suggest that CDSs mute the stock market reaction to a credit rating downgrade by alleviating the financing frictions faced by downgraded firms.
Chapter
While CDS Indices have grown in popularity during then last ten years, there are many structural problems inherent in the associated index calculation methodologies, which create substantial tracking errors. As of 2018, the global CDS market covered notional amounts that exceeded US$50 trillion.
Preprint
Using a framework motivated by the Adaptive Markets Hypothesis (AMH) I explore the extent to which the financial statement (FS) is relevant for Credit Default Swap (CDS) trading. I propose a Bayesian Model Averaging approach to examine properties of accounting metrics that enter the trading heuristics of the market participants. Hypothesis-testing is conducted on various horizons around the announcement of corporate results. The diversity of trading rules and the shift in the heuristics mix that occurred after 2008, support the AMH perspective. Overall, results show that there is a significant component of profit-motivated trading in the CDS market that relies on financial statement information.
Chapter
Empirical academic research regarding the impact of credit default swaps (“CDSs”) on lenders to reference entities and reference entities themselves yield the following general results: (i) CDSs are generally used by lenders to fine-tune their desired risk/return profiles; (ii) the impact of CDS availability on banks’ credit exposure monitoring is bank-specific; (iii) the availability of CDSs positively impacts the supply of credit to reference entity borrowers, impacts the design of syndicated loan facilities, and affects reference entity borrowing costs differently based on the credit characteristics of borrowers and structures of their loans; (iv) the availability of CDSs influences capital structure and financing decisions of reference entity borrowers; and (v) creditors with significant CDS-hedged exposures can impact the bankruptcy decisions of borrowers both positively and negatively.
Chapter
No-arbitrage relationships characterize relative prices of credit default swaps (“CDSs”) vis-à-vis bonds and equities issued by the same reference entities. We review the empirical academic literature on which of the three markets is the Primary Price Discovery Market (“PPDM”) and find that CDS spreads lead corresponding cash bond prices in price discovery. The PPDM is more empirically ambiguous when comparing CDSs and equities. We also review the empirical evidence on the impact of the introduction of CDSs on bond and equity markets’ liquidity, which broadly demonstrates that the introduction of single-name CDS trading initially has adverse impacts on the liquidity of related debt and equity markets, but that those effects are transitory and may be later reversed as the related markets reach a joint equilibrium.
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Chapter
This chapter: (1) surveys the literature on anomalies in the NPV/MIRR/IRR model and related methods and shows the varied treatment of discount rates in analyses of NPV/MIRR/IRR and the recognized and unrecognized fallacy of treating discount rates as a key variable; (2) explains the conditions under which negative discount rates may be feasible and rational; (3) explains why the discount rate is often the perceived critical variable in the NPV/MIRR/IRR model and related approaches; (4) explains why the concept of plain interest rates and forward rates (unadjusted for behavioral biases, taxes, and transaction costs) may not be entirely correct.
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This paper examines the causal effect of index creation on security prices in related markets. Using a novel identification strategy, I document persistent treatment effects attributable to index inclusion. Variation in the difference between bond and credit default swap (CDS) spreads, known as the basis, is caused by variation in measures of index inclusion. Using proprietary data on the voting outcomes of the Markit CDX index formation process, I identify a persistent effect that contrasts with the predictions of existing theoretical models of the basis. Also, I document evidence of equity market contagion for firms included in a high number of credit indices.
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Credit default swaps (CDS) have grown to be a multi-trillion-dollar, globally important market. The academic literature onCDS has developed in parallel with the market practices, public debates, and regulatory initiatives in this market. We selectively review the extant literature, identify remaining gaps, and suggest directions for future research. We present a narrative including the following four aspects. First, we discuss the benefits and costs of CDS, emphasizing the need for more research in order to better understand the welfare implications. Second, we provide an overview of the postcrisis market structure and the new regulatory framework for CDS. Third, we place CDS in the intersection of law and finance, focusing on agency conflicts and financial intermediation. Last, we examine the role of CDS in international finance, especially during and after the recent sovereign credit crises. Expected final online publication date for the Annual Review of Financial Economics Volume 8 is November 06, 2016. Please see http://www.annualreviews.org/page/journal/pubdates for revised estimates.
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Credit default swaps (CDS) have been growing in importance in the global financial markets. However, their role has been hotly debated, in industry and academia, particularly since the credit crisis of 2007–2009. 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 conventions. The third section discusses the pricing of CDS, from the perspective of no-arbitrage principles, 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 affected the characteristics of the bond and equity markets, with an emphasis on market efficiency, price discovery, information flow, and liquidity. Attention is also paid to the CDS-bond basis, the wedge between the pricing of the CDS and its reference bond, and the mispricing between the CDS and the equity market. The fifth section examines the effect of CDS trading on firms' credit and bankruptcy risk, and how it affects corporate financial policy, including bond issuance, capital structure, liquidity management, and corporate governance. The sixth section analyzes how CDS impact the economic incentives of financial intermediaries. The seventh section reviews the growing literature on sovereign CDS and highlights the major differences between the sovereign and corporate CDS markets. In the eight section, we discuss CDS indices, especially the role of synthetic CDS index products backed by residential mortgage-backed securities during the financial crisis. We close with our suggestions for promising future research directions on CDS contracts and markets.
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We develop a simple model of the effect of public transaction reporting on trade execution costs and test it using a sample of institutional trades in corporate bonds, before and after initiation of the TRACE reporting system. Trade execution costs fell approximately 50% for bonds eligible for TRACE transaction reporting, and 20% for bonds not eligible for TRACE reporting, suggesting the presence of a “liquidity externality.” The key results are robust to changes in variables, such as interest rate volatility and trading activity that might also affect execution costs. Market shares and the cost advantage to large dealers decreased post-TRACE. These results indicate that market design can have first-order effects, even for sophisticated institutional customers.
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Many have claimed that credit default swaps (CDSs) have lowered the cost of debt financing to firms by creating new hedging opportunities and information for investors. This paper evaluates the impact that the onset of CDS trading has on the spreads that underlying firms pay to raise funding in the corporate bond and syndicated loan markets. Employing a range of methodologies, we fail to find evidence that the onset of CDS trading lowers the cost of debt financing for the average borrower. Further, we uncover economically significant adverse effects on risky and informationally opaque firms.
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Two people, 1 and 2, are said to have common knowledge of an event E if both know it, 1 knows that 2 knows it, 2 knows that 1 knows is, 1 knows that 2 knows that 1 knows it, and so on. THEOREM. If two people have the same priors, and their posteriors for an event A are common knowledge, then these posteriors are equal.
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We analyze the introduction of a nonredundant option, which completes the markets, and the effects of this on information revelation and risk sharing. The option alters the interaction between liquidity and insider trading. We find that the option mitigates the market breakdown problem created by the combination of market incompleteness and asymmetric information. The introduction of the option has ambiguous consequences on the informational efficiency of the market. On the one hand, by avoiding market breakdown, it enables trades to occur and convey information. On the other hand, the introduction of the option enlarges the set of trading strategies the insider can follow. This can make it more difficult for the market makers to interpret the information content of trades and consequently can reduce the informational efficiency of the market. The introduction of the option also has an ambiguous effect on the profitability of insider trades, which can either increase or decrease depending on parameter values.
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The traditional pricing methodology in finance values derivative securities as redundant assets that have no impact on equilibrium prices and allocations. This paper demonstrates that, when the market is incomplete, primary and derivative asset markets, generically, interact: the valuation of derivative and primary security prices depend on the contractual characteristics of the derivative assets available. In a version of the Mossin mean-variance model, the authors analyze an equilibrium in which a call option (derivative asset) is traded and the equilibrium stock price (primary asset) increases when the options market is opened. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.
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Firms raise money from banks and the bond market. Banks sell loans in a secondary market to recycle their funds or to trade on private information. Liquidity in the loan market depends on the relative likelihood of each motive for trade and affects firms' optimal financial structure. The endogenous degree of liquidity is not always socially optimal: There is excessive trade in highly rated names, and insufficient liquidity in riskier bonds. We provide testable implications for prices and quantities in primary and secondary loan markets, and bond markets. Further, we posit that risk-based capital requirements may be socially desirable. Copyright (c) 2008 by The American Finance Association.
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This paper investigates the informational role of transactions volume in options markets. We develop an asymmetric information model in which informed traders may trade in option or equity markets. We show conditions under which informed traders trade options, and we investigate the implications of this for the linkage between markets. Our model predicts an important informational role for the volume of particular types of option trades. We empirically test our model's hypotheses with intraday option data. Our main empirical result is that negative and positive option volumes contain information about future stock prices. Copyright The American Finance Association 1998.