Role of Credit Default Swap in Bubbles and Crashes
We formulate strategic aspects of speculative arbitrageurs in a stock market as a generalization of timing game with behavioral types explored by Matsushima (2013b). A company raises huge funds during the bubble driven by positive feedback tradersâ€™ euphoria by issuing shares in a socially harmful manner. The arbitrageurs borrow money from positive feedback traders under a regulation on leverage ratio and purchase credit default swaps defined as bubble-contingent claim from them. We demonstrate a theoretical ground for considering the availability of credit default swap associated with a high leverage ratio as a powerful policy method to deter harmful bubbles.
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