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Credit Derivatives: Capital Requirements and Strategic Contracting


  • Antonio Nicolo'

    () (University of Padua)

  • Loriana Pelizzon

    () (University of Venice)


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.

Suggested Citation

  • Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
  • Handle: RePEc:pad:wpaper:0006

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    References listed on IDEAS

    1. Gunter Franke & Jan Pieter Krahnen, 2007. "Default Risk Sharing between Banks and Markets: The Contribution of Collateralized Debt Obligations," NBER Chapters,in: The Risks of Financial Institutions, pages 603-634 National Bureau of Economic Research, Inc.
    2. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 25-54, August.
    3. Bank for International Settlements, 2003. "Credit risk transfer," CGFS Papers, Bank for International Settlements, number 20.
    4. Repullo, Rafael & Suarez, Javier, 2004. "Loan pricing under Basel capital requirements," Journal of Financial Intermediation, Elsevier, vol. 13(4), pages 496-521, October.
    5. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, vol. 32(2), pages 371-387, May.
    6. In-Koo Cho & David M. Kreps, 1987. "Signaling Games and Stable Equilibria," The Quarterly Journal of Economics, Oxford University Press, vol. 102(2), pages 179-221.
    7. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June.
    8. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
    9. Froot, Kenneth A. & Stein, Jeremy C., 1998. "Risk management, capital budgeting, and capital structure policy for financial institutions: an integrated approach," Journal of Financial Economics, Elsevier, vol. 47(1), pages 55-82, January.
    10. Gorton, Gary B. & Pennacchi, George G., 1995. "Banks and loan sales Marketing nonmarketable assets," Journal of Monetary Economics, Elsevier, vol. 35(3), pages 389-411, June.
    11. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
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    Cited by:

    1. Nicolò, Antonio & Pelizzon, Loriana, 2008. "Credit derivatives, capital requirements and opaque OTC markets," Journal of Financial Intermediation, Elsevier, vol. 17(4), pages 444-463, October.
    2. Calice, Giovanni & Ioannidis, Christos, 2012. "An empirical analysis of the impact of the credit default swap index market on large complex financial institutions," International Review of Financial Analysis, Elsevier, vol. 25(C), pages 117-130.
    3. Kiff, John & Kisser, Michael, 2014. "A shot at regulating securitization," Journal of Financial Stability, Elsevier, vol. 10(C), pages 32-49.
    4. Wagner, Wolf & Marsh, Ian W., 2006. "Credit risk transfer and financial sector stability," Journal of Financial Stability, Elsevier, vol. 2(2), pages 173-193, June.
    5. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
    6. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.

    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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