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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.

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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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  1. Elizalde, Abel & Repullo, Rafael, 2004. "Economic and Regulatory Capital: What is the Difference?," CEPR Discussion Papers 4770, C.E.P.R. Discussion Papers.
  2. 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.
  3. 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.
  4. Leland, Hayne E & Pyle, David H, 1977. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Journal of Finance, American Finance Association, vol. 32(2), pages 371-87, May.
  5. 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.).
  6. Günter Franke & Jan Pieter Krahnen, 2005. "Default risk sharing between banks and markets: the contribution of collateralized debt obligations," CoFE Discussion Paper 05-04, Center of Finance and Econometrics, University of Konstanz.
  7. Bank for International Settlements, 2003. "Credit risk transfer," CGFS Papers, Bank for International Settlements, number 20, April.
  8. Kenneth A. Froot & Jeremy C. Stein, 1996. "Risk Management, Capital Budgeting and Capital Structure Policy for Financial Institutions: An Integrated Approach," NBER Working Papers 5403, National Bureau of Economic Research, Inc.
  9. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June.
  10. Repullo, Rafael & Suarez, Javier, 2004. "Loan pricing under Basel capital requirements," Journal of Financial Intermediation, Elsevier, vol. 13(4), pages 496-521, October.
  11. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  12. 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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