Market Efficiency and Default Risk: Evidence of an Anomaly from the CDS and Loan CDS Markets

Abstract

On the basis of the documented oligopolistic structure of the CDS and Loan CDS markets, we formulate a Cournot-type oligopoly market equilibrium model on the dealer side of simultaneous trading in both markets. We use a novel formulation that recognizes both positive and negative quantities and elasticities in the demand functions in the two markets; we extend the model to include trading costs. It is shown that in equilibrium dealers take opposite positions in the two markets. The oligopoly equilibrium also identifies a relation between the observed premiums, the elasticities and the recovery rates upon default in the two markets. This relation differs from the one that prevails under a competing no arbitrage model, with which it coincides only under perfect competition. It is, however, consistent with observed significantly positive and persistent earnings from a simulated portfolio of a very large number of matured contracts in the two markets with otherwise identical characteristics, which are robust in the presence of trading costs. The oligopoly model also predicts that such profitable portfolios cannot be explained by alternative absence or limits to arbitrage theories. Extensive empirical tests confirm these predictions and reject decisively these competing theories. The observed profitable portfolios also respond to the recent economic crisis as predicted by the oligopoly model.