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Credit derivatives, capital requirements and opaque OTC markets

  • Nicolò, Antonio
  • Pelizzon, Loriana

In this paper we study the optimal design of credit derivative contracts when banks have private information about their ability in the loan market and are subject to capital requirements. First, we prove that when banks are subject to a maximum loss capital requirement the optimal signaling contract is a binary credit default basket. Second, we show that if credit derivative markets are opaque then banks cannot commit to terminal-date risk exposure, and therefore the optimal signaling contract is more costly. The above results allow us to discuss the potential implications of different capital adequacy rules for the credit derivative markets.

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Article provided by Elsevier in its journal Journal of Financial Intermediation.

Volume (Year): 17 (2008)
Issue (Month): 4 (October)
Pages: 444-463

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Handle: RePEc:eee:jfinin:v:17:y:2008:i:4:p:444-463
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/622875

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  1. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
  2. Alan D. Morrison, 2005. "Credit Derivatives, Disintermediation, and Investment Decisions," The Journal of Business, University of Chicago Press, vol. 78(2), pages 621-648, March.
  3. Gregory R. Duffee & Chunsheng Zhou, 1997. "Credit derivatives in banking: useful tools for managing risk?," Finance and Economics Discussion Series 1997-13, Board of Governors of the Federal Reserve System (U.S.).
  4. Adam B. Ashcraft & João A. C. Santos, 2007. "Has the credit derivatives swap market lowered the cost of corporate debt?," Staff Reports 290, Federal Reserve Bank of New York.
  5. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  6. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November.
  7. Sandeep Dahiya & Manju Puri & Anthony Saunders, 2003. "Bank Borrowers and Loan Sales: New Evidence on the Uniqueness of Bank Loans," The Journal of Business, University of Chicago Press, vol. 76(4), pages 563-582, October.
  8. Gary Gorton & George Pennacchi, 1990. "Banks and Loan Sales: Marketing Non-Marketable Assets," NBER Working Papers 3551, National Bureau of Economic Research, Inc.
  9. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  10. Bernadette A. Minton & René Stulz & Rohan Williamson, 2005. "How Much Do Banks Use Credit Derivatives to Reduce Risk?," NBER Working Papers 11579, National Bureau of Economic Research, Inc.
  11. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," Center for Financial Institutions Working Papers 96-28, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. Guillaume Plantin & Christine A Parlour, . "Credit Risk Transfer," GSIA Working Papers 2005-E45, Carnegie Mellon University, Tepper School of Business.
  13. Cho, In-Koo & Kreps, David M, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 179-221, May.
  14. Peter M. DeMarzo, 2005. "The Pooling and Tranching of Securities: A Model of Informed Intermediation," Review of Financial Studies, Society for Financial Studies, vol. 18(1), pages 1-35.
  15. Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
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