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Sovereign Debt and Credit Default Swaps

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Abstract

ow do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct effects feedback into default decisions. Our novel identification strategy exploits confidential microdata to quantify the extent of trading frictions and risk-sharing. The model generates realistic CDS-bond basis deviations, bid/ask spreads, and CDS volumes and positions. Our baseline specification predicts large effects of frictions generally but small spillovers from a naked CDS ban. These predictions hinge crucially on the identified parameters.

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  • Gaston Chaumont & Grey Gordon & Bruno Sultanum & Elliot Tobin, 2023. "Sovereign Debt and Credit Default Swaps," Working Paper 23-05, Federal Reserve Bank of Richmond.
    • Handle: RePEc:fip:fedrwp:95889
    DOI: 10.21144/wp23-05
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    More about this item

    Keywords

    sovereign debt; CDS; Directed search; Over-the-counter;
    All these keywords.

    JEL classification:

    • F34 - International Economics - - International Finance - - - International Lending and Debt Problems
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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