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Credit Derivatives: Capital Requirements and Strategic Contracting

Author

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  • Antonio Nicolo'

    (University of Padua)

  • Loriana Pelizzon

    (University of Venice)

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.

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

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    Cited by:

    1. Darrell Duffie, 2008. "Innovations in credit risk transfer: implications for financial stability," BIS Working Papers 255, Bank for International Settlements.
    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. 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.
    4. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
    5. 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.
    6. Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.
    7. Kiff, John & Kisser, Michael, 2014. "A shot at regulating securitization," Journal of Financial Stability, Elsevier, vol. 10(C), pages 32-49.

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    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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