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A Theory of Liquidity Spillover between Bond and CDS Markets

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  • Batchimeg Sambalaibat

Abstract

I build a search model of bond and credit default swap (CDS) markets with endogenous investor participation and show that shorting bonds through CDS increases the liquidity and price of bonds. By allowing investors to trade the credit risk of bonds without trading the bonds, CDS introduction expands the set of feasible trades and attracts investors into the credit market. Because search is nondirected within the credit market, new investors also trade bonds and consequently increase their price and liquidity. My results suggest that naked CDS bans increased sovereigns’ borrowing costs and thereby exacerbated the 2010–2012 European debt crisis.

Suggested Citation

  • Batchimeg Sambalaibat, 2022. "A Theory of Liquidity Spillover between Bond and CDS Markets," The Review of Financial Studies, Society for Financial Studies, vol. 35(5), pages 2525-2569.
    • Handle: RePEc:oup:rfinst:v:35:y:2022:i:5:p:2525-2569.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhab094
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    Cited by:

    1. Maximilian Jager & Frederick Zadow, 2023. "Clear(ed) Decision: The Effect of Central Clearing on Firms Financing Decision," CRC TR 224 Discussion Paper Series crctr224_2023_445, University of Bonn and University of Mannheim, Germany.
    2. Gaston Chaumont & Grey Gordon & Bruno Sultanum & Elliot Tobin, 2023. "Sovereign Debt and Credit Default Swaps," Working Paper 23-05, Federal Reserve Bank of Richmond.

    More about this item

    JEL classification:

    • F30 - International Economics - - International Finance - - - General
    • G1 - Financial Economics - - General Financial Markets
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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