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Credit Default Swaps

Paper Session

Friday, Jan. 5, 2018 10:15 AM - 12:15 PM

Loews Philadelphia, Commonwealth Hall A2
Hosted By: American Finance Association
  • Chair: Greg Duffee, Johns Hopkins University

Why Do Investors Buy Sovereign Default Insurance?

Patrick Augustin
,
McGill University
Valeri Sokolovski
,
HEC Montreal
Marti G. Subrahmanyam
,
New York University
Davide Tomio
,
Darden School of Business - University of Virginia

Abstract

We provide empirical evidence that the size of a country's debt, together with its level of economic activity, explains about 75% of the cross-country variation in net insured positions of sovereign credit default swaps (CDS). Based on a novel data set of net notional amounts outstanding for single-name sovereign CDS from October 2008 to September 2015, we show that the net notional amount outstanding amounts of sovereign CDS contracts are mostly driven by local factors. Unlike for CDS spreads, for which a single principal component accounts for 54 percent of the cross-sectional variation, common global factors explain only up to 7 percent of the variation in sovereign CDS net notional amounts outstanding. This is consistent with the conclusion that net sovereign debt insurance is driven primarily by country-specific risk. Thus, even in the absence of granular time-series data, we are able to document evidence on two economic channels that explain the net trading in sovereign CDS: (a) country-specific credit risk shocks that change banks' capital requirements based on regulatory rating thresholds, and (b) the issuance of sovereign debt.

Market Structure and Transaction Costs of Index CDSs

Pierre Collin-Dufresne
,
Swiss Federal Institute of Technology-Lausanne
Benjamin Junge
,
Swiss Federal Institute of Technology-Lausanne
Anders Trolle
,
HEC Paris

Abstract

Using transaction data, we study the two-tiered structure of the index CDS market
after the implementation of the Dodd-Frank Act. We identify dealer-to-client (D2C)
trades and interdealer (D2D) trades. Average transaction costs are higher for D2C
trades, reflecting higher average price impact. D2C trades Granger-cause D2D trades
consistent with the interdealer market being used for managing inventory risk. Unique
order-book data show that D2D transaction costs and price impacts vary across trading
protocols, with mid-market matching and workup attracting liquidity-motivated trades.
D2C prices are typically better than those available on the main interdealer limit order
book, which may explain the endurance of the two-tiered market structure.

Mitigating Counterparty Risk

Yalin Gunduz
,
Deutsche Bundesbank

Abstract

This paper provides initial evidence on counterparty risk-mitigation activities of financial institutions on the basis of Depository Trust and Clearing Corporation's (DTCC) proprietary bilateral credit default swap transactions and positions. We show that financial institutions that are active buyers of protection from a specific counterparty undertake successive contracts and purchase protection written on them, even avoiding wrong-way risk mitigation. Higher stock return and CDS price volatility, lower past stock returns, and higher CDS prices of the counterparty are shown to have an increasing effect on the hedging behaviour against the counterparty. As the current regulatory frameworks explicitly formulate any protection purchase on the counterparty would diminish the required capital, this type of risk mitigation could follow regulatory capital relief motives and provides a viable hedging instrument beyond receiving coverage through collateral.

Credit Derivatives and Firm Investment

George Batta
,
Claremont McKenna College
Fan Yu
,
Claremont McKenna College

Abstract

We examine the effect of credit default swap (CDS) trading on firm investment, finding evidence of a post-CDS introduction drop in debt issuance and M&A activities, which remains robust to propensity score matching and instrumenting CDS introduction using lenders' FX hedging activities. Further analysis reveals a CDS introduction-year increase in debt financing and investment, and suggests that the ex ante commitment benefit of CDS in reducing strategic default, the ex post increase in bankruptcy risk and debt overhang, and the credit supply expansion by banks using CDS to reduce regulatory capital requirements all play a role in explaining these results.
Discussant(s)
Tobias Berg
,
Frankfurt School of Finance & Management
Lawrence Glosten
,
Columbia University
Emil Siriwardane
,
Harvard University
Bastian von Beschwitz
,
Federal Reserve Board
JEL Classifications
  • G1 - General Financial Markets