A Theory of Liquidity Spillover Between Bond and CDS Markets

Batchimeg Sambalaibat - Jul 07, 2021

Working Paper No.  00072-00

I build a search model of bond and credit default swap (CDS) markets with endogenous investor participation and show that shorting bonds through CDS increases the liquidity and price of bonds. By allowing investors to trade the credit risk of bonds without trading the bonds, CDS introduction expands the set of feasible trades and attracts investors into the credit market. Because search is non-directed within the credit market, new investors also trade bonds and consequently increase their price and liquidity. My results suggest that naked CDS bans increased sovereigns' borrowing costs and thereby exacerbated the 2010--2012 European debt crisis.

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block trading credit default swaps (CDS) search frictions over-the-counter (OTC) markets market liquidity costly participation CDS-bond basis short-selling credit risk