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Credit Derivatives, Capital Requirements and Opaque OTC Markets

  • Antonio Nicolo’

    (University of University of Padua, IFS and CEPR)

  • Loriana Pelizzon

    Department of Economics, University Of Venice Ca’ Foscari)

How does bank capital regulation affect the design of credit derivative contracts? How does the opacity of the OTC credit derivative markets affect these contracts? In this paper we address these issues and characterize the optimal security design in several settings. We show that both the level of the banks' cost of capital and the opacity of the credit derivative markets do affect the form of the optimal separating contract and the level of the banks' profits. Moreover, our results suggest that the optimal contracts are largely dependent on bank regulation. More specifically, the introduction of Basel II may prevent the use of the equity tranche in CDO contracts as a signaling device. In addition, the presence of private credit derivative contracts would make the use of signaling contracts able to solve the adverse selection problem quite expensive.

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Paper provided by Department of Economics, University of Venice "Ca' Foscari" in its series Working Papers with number 2006_58.

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Length: 38
Date of creation: 2006
Date of revision:
Handle: RePEc:ven:wpaper:2006_58
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  1. 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.
  2. 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.
  3. In-Koo Cho & David M. Kreps, 1997. "Signaling Games and Stable Equilibria," Levine's Working Paper Archive 896, David K. Levine.
  4. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
  5. Allen, Franklin & Carletti, Elena, 2005. "Credit risk transfer and contagion," CFS Working Paper Series 2005/25, Center for Financial Studies (CFS).
  6. 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.
  7. 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.
  8. Minton, Bernadette A. & Stulz, Rene M. & Williamson, Rohan, 2005. "How Much Do Banks Use Credit Derivatives to Reduce Risk?," Working Paper Series 2005-17, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  9. Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
  10. 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.
  11. 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.
  12. Peter DeMarzo & Darrell Duffie, 1999. "A Liquidity-Based Model of Security Design," Econometrica, Econometric Society, vol. 67(1), pages 65-100, January.
  13. Gary Gorton & George Pennacchi, 1990. "Banks and Loan Sales: Marketing Non-Marketable Assets," NBER Working Papers 3551, National Bureau of Economic Research, Inc.
  14. repec:tpr:qjecon:v:90:y:1976:i:4:p:651-66 is not listed on IDEAS
  15. Guillaume Plantin & Christine A Parlour, . "Credit Risk Transfer," GSIA Working Papers 2005-E45, Carnegie Mellon University, Tepper School of Business.
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