Credit Derivatives: Capital Requirements and Strategic Contracting

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Credit Derivatives: Capital Requirements and Strategic Contracting

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Antonio Nicolo' () (University of Padua)
Loriana Pelizzon () (University of Venice)

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Abstract

In this paper we investigate the problem of a bank, which, due to the presence of capital requirements, needs to issue credit derivatives. Because of asymmetric information in the loan and credit risk transfer markets, banks face an adverse selection problem, sharpened by the fact that credit derivative contracts are not publicly observable. We show that high-quality banks can use CDO contracts to signal their own type, even when credit derivatives are private contracts. Also a menu of contracts with a first-to-default basket and a credit default swap conditioned to the default of the first asset, can be used as a signalling device. Moreover, this last menu of contracts generates larger profits for high-quality banks than the CDO contract if the cost of capital and the loan interest rates are su¢ ciently high.

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Publisher Info
Paper provided by Dipartimento di Scienze Economiche "Marco Fanno" in its series "Marco Fanno" Working Papers with number 0006.

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Length: 33 pages
Date of creation: Oct 2005
Date of revision:
Handle: RePEc:pad:wpaper:0006

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Find related papers by JEL classification:
G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Mortgages
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information

This paper has been announced in the following NEP Reports:

NEP-ALL-2005-10-29 (All new papers)
NEP-FIN-2005-10-29 (Finance)
NEP-FMK-2005-10-29 (Financial Markets)

References listed on IDEAS
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Other versions:
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Other versions:
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Full references

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Franklin Allen & Elena Carletti, 2005. "Credit Risk Transfer and Contagion," CFS Working Paper Series 2005/25, Center for Financial Studies. [Downloadable!]
Other versions:
- Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January. [Downloadable!] (restricted)

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