Credit Default Swap Positions Research Articles

Sovereign debt and credit default swaps

How do credit default swaps (CDS) affect sovereign debt markets? We analyze how liquidity, exposure to default risk, and regulation affect the answer to this question using a sovereign debt model where investors trade bonds and CDS over the counter via directed search. Restricting portfolios can improve bond prices and bond-market activity, but the net effect depends on relative frictions in bond and CDS markets, the exposure of investors, and how the sovereign responds to the policy. Our novel identification strategy exploits confidential microdata to quantify trading frictions and the exposure distribution. The calibrated model generates realistic CDS-bond basis deviations, bid–ask spreads, and CDS volumes and positions. Our baseline specification predicts trading frictions and an inability to short sell bonds significantly improves sovereign debt prices, but policies that restrict CDS trading have small effects.

Sovereign Debt and Credit Default Swaps

How do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct effects feedback into default decisions. Our novel identification strategy exploits confidential microdata to quantify the extent of trading frictions and risk-sharing. The model generates realistic CDS-bond basis deviations, bid/ask spreads, and CDS volumes and positions. Our baseline specification predicts large effects of frictions generally but small spillovers from a naked CDS ban. These predictions hinge crucially on the identified parameters.

Managerial tone and investors' hedging activities: Evidence from credit default swaps

AbstractThis study examines investors' hedging behaviours in the credit default swap (CDS) market in response to the managerial tone of the Management Discussion and Analysis section in 10‐K/Q flings. Utilising CDS positions data derived from the Depository Trust & Clearing Corporation, we first document that managerial tone is negatively associated with CDS positions. We further find that such an effect is stronger for investors with less reliable alternative information channels and for firms with greater default probability. Our inferences persist when using the abnormal tone from a two‐stage analysis, when using change model regression, and when filtering out other potential confounding impacts. The results of this study advance the understanding of how the linguistic tone presented by management affects CDS market investors' hedging decision making through the use of public accounting information in financial disclosures.

The bullwhip effect and credit default swap market: A study based on firm-specific bullwhip effect measure

This paper explores the financial implications of the bullwhip effect in the credit default swap (CDS) market. Using firms' supply chain hierarchical positions to proxy for exposure to the bullwhip effect and CDS positions data, we find that positions further upstream within the supply chain network are associated with more CDS positions with economically significant magnitudes, suggesting that investors employ CDS contracts to hedge against the financial risk of underlying firms that are exposed to a greater bullwhip effect. The positive impact of the bullwhip effect on CDS positions is more pronounced for firms with greater information uncertainty. Our results hold after we control for sample selection bias, rule out an industry-level bullwhip effect, mitigate the effect of hedging demand for accounts payable and debt exposure, and remove the influence of risk pooling, exposure to productivity shocks, and the financial crisis. This study contributes to both the supply chain management and finance literature.

Credit Default Swaps

Credit default swaps (CDS) are the most common type of credit derivative. This paper provides a brief history of the CDS market and discusses its main characteristics. After describing the basic mechanics of a CDS, I present a simple valuation framework that focuses on the relationship between conditions in the cash and CDS markets as well as an approach to mark to market existing CDS positions. The discussion highlights how the 2008 global financial crisis helped shape current practices and conventions in the CDS market, including the widespread adoption of standardized coupons and upfront premiums and the increased reliance on centralized counterparties. I also address CDS indexes--focusing on their growing role as key indicators of investors’ attitudes toward credit risk--and briefly examine their behavior during periods of acute financial or economic dislocations, including those associated with the COVID-19 pandemic.

Standardization, transparency initiatives, and liquidity in the CDS market

We investigate liquidity changes in the credit default swap (CDS) market around two events that increased market transparency and standardization during the Great Financial Crisis: the dissemination of CDS positions starting in November 2008, and the implementation of the Small Bang in July 2009. We build an econometric model based on bid and ask quotes to measure liquidity in thinly traded CDSs. We find that, after the release of CDS positions, the market-wide deterioration in liquidity is less important for banks, consistent with information revelation alleviating systemic risk uncertainty. The Small Bang also improved liquidity, particularly for more illiquid CDSs.

“Less is More”: Credit Default Swaps and Firm Cyclicality

Firm cyclicality decreases by around 40% after the inception of credit default swap (CDS) trading. The effect is due to CDS firms’ lower asset growth-GDP growth sensitivity in good times and stronger for firms facing a more severe exacting creditor problem. The cyclicality-reducing effect of CDS trading cannot be explained with bank lending cyclicality or market beta. Our finding is robust for alternative measures such as outstanding CDS positions, firm employment growth, and state-/industry level cyclicality. Moreover, CDS trading impedes unhealthy growth and enhances profitability and market value. The evidence highlights an important disciplining effect of CDS on corporate growth.

CDS Auctions: An Overview

We discuss the historical background of the credit default swap (CDS) market, why CDS auctions were developed, and the most recent literature. We describe the auction rules using the Toys R Us auction as an example. Furthermore, we discuss the theoretical and empirical results presented in Chernov et al. (2013). Empirically, we extend their data to include more recent CDS auctions. Our results support their findings that dealers have incentive to manipulate the auction price downward when the net open interest is positive. Finally, we use novel dealer-level CDS positions to support Chernov et al.'s (2013) findings.

Credit Default Swaps and Bank Loan Sales: Evidence from Bank Syndicated Lending

Do banks use credit default swap (CDS) hedging to substitute for loan sales? By tracking banks’ lending exposures and CDS positions on individual firms, we find that banks use CDS hedging to complement rather than to substitute for loan sales. Consequently, bank loan sales are higher for firms that are actively traded in the CDS market. In addition, we find evidence that suggests banks sell CDS protection as credit enhancements to facilitate loan sales. This study employs identification strategies similar to the “twin study” design to separate the effects of borrower-side and lender-side factors, and to minimize the omitted-variables bias.

Counterparty Risk in Bond Mutual Funds: Evidence from Credit Default Swaps Positions

We examine the credit default swaps (CDS) positions of bond mutual funds over 2004-2009. We find that CDS are more commonly used by funds with the greatest transaction-cost benefit and that CDS usage is associated with lower flow-motivated trading in the bond market. We also find that bond funds’ net-buying of CDS protection dropped significantly during the 2007-2009 financial crisis. Consistent with bond funds’ avoiding buy protection positions out of heightened concerns about the counterparty risk of swap dealers, we find that funds are more likely to close existing buy-protection CDS that have greater counterparty credit risk, as measured by positions in which the counterparty has a high default probability or a high default correlation with the reference entity. Furthermore, as a further contributor to a decrease in net-buy protection during the crisis, we find an increase in funds’ selling of CDS protection during the crisis, especially to banks in greater financial distress. Finally, we show that the portfolios of CDS-users displayed significantly higher systematic credit risk and lower returns during the crisis.

Inventory Effects, the Winner’s Curse, and Bid Shading in Credit Default Swap Auction Outcomes

This article studies bidding behavior in the novel and complex auctions that, since 2005, have determined recovery rates in the multi-trillion dollar credit default swap (CDS) market. We find that bids are substantially influenced by inventory effects (bidders’ CDS positions entering the auction), market illiquidity, and “winners curse” considerations. The economically and statistically significant extent of “bid-shading” induced by these factors explains why auction prices deviate significantly (on average >16%) from pre- and post-auction market prices for the same instruments even while auction-generated information is significantly informative for post-auction market price formation.

Do Market Makers Lean Against the Wind? Evidence from the Credit Default Swaps Market

This paper examines how a market maker adjusts its holdings of credit default swaps (CDS) in response to changes in CDS spreads over different time intervals and finds mixed evidence. Specifically, the negative correlation between weekly changes in CDS spreads and changes in net CDS positions suggests that market makers “lean against the wind” and absorb liquidity shocks in the short run. This correlation, however, become positive over the monthly interval, implying market makers follow the trends. Finally, this correlation is insignificant over the quarterly interval, suggesting market makers do not bet on the direction of the CDS spread over the long run.

Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage

In a naked credit default swap (CDS) position, a party pays an income stream to a seller of protection to swap away default risk on an underlying defaultable security without actually holding this reference instrument. Using mark-to-market returns on a large cross section of CDS positions, held independent from their reference entity, we implement a novel test to establish whether their inclusion in an optimised portfolio is replicable by a large set of alternative assets. Overall, we find significant excess returns of over 28% per annum against an optimised benchmark, we speculate that it is these characteristics that could be driving a bubble in the CDS market.

Strategic conduct in credit derivative markets

This paper reviews recent research at the intersection of industrial organization and corporate finance on credit default swap (CDS) markets. These markets have been at the center of the financial crisis of 2007–09 and many aspects of their operation are not well understood. The paper covers topics such as counterparty risk in CDS markets, the "empty creditor problem," "naked" CDS positions, super-senior status of credit (and other) derivatives in Chapter 11 bankruptcy, and strategic behavior in CDS settlement auctions.

CDS and the Resolution of Financial Distress

The dramatic growth of Credit Default Swaps (CDS)—contracts that allow creditors to hedge their default exposure or take leveraged credit positions—threatens to complicate the resolution of financial distress in ways that existing reorganization methods and institutions have yet to adapt to. CDS contracts undermine a major premise that underlies current reorganization methods—namely, that the holder of legal rights has, and is motivated by, corresponding economic interests. Because hedging in the CDS markets immunizes creditors from the debtor's financial condition, they effectively separate their legal rights and economic interests.In this article, the authors discuss the challenges this separation poses for the resolution of distress both in and out of bankruptcy, and consider ways in which “on‐ground” realities may be reconciled with the legal structure that underlies the resolution of distress. At a minimum, disclosure of CDS positions in times of financial distress—along the lines of the disclosures presently required of equity investors under the Williams Act—are an essential first step toward a solution.

The Use of Credit Default Swaps by U.S. Fixed-Income Mutual Funds

We examine the use of credit default swaps (CDS) in the U.S. mutual fund industry. We find that among the largest 100 corporate bond funds the use of CDS has increased from 20% in 2004 to 60% in 2008. Among CDS users, the average size of CDS positions (measured by their notional values) has increased from 2% to almost 14% of a fund’s net asset value. Some funds exceed this level by a wide margin. CDS are predominantly used to increase a fund’s exposure to credit risks rather than to hedge credit risk. Consistent with fund tournaments, underperforming funds use multi-name CDS to increase their credit risk exposures. Finally, funds that use CDS underperform funds that do not use CDS. Part of this underperformance is caused by poor market timing.

Are CDS Auctions Biased?

We study the design of settlement auctions for credit default swaps (CDS). We nd that the one-sided design of CDS auctions currently used in practice gives CDS buyers and sellers strong incentives to distort the nal auction price, in order to prot from existing CDS positions. In the absence of frictions, the current auction mechanism tends to overprice defaulted bonds given an excess supply and underprice them given an excess demand. We propose a double auction to mitigate price biases and provide robust price discovery. The predictions of our theory on bidding behavior are consistent with CDS auction data.

Are There Benefits to Being Naked?

Naked credit default swap (CDS) positions and so called capital structure arbitragers are a controversial topic in modern finance. In a naked CDS position a party pays an income stream to a seller of protection to swap away default risk on an underlying bond without actually holding the underlying bond. In this paper we construct sector level portfolios of 2,846 corporate CDS positions for the US, UK, Japan and the Eurozone and incorporate these into a very broad portfolio of 42,559 conventional assets observed over seven years at the daily frequency. We find compelling evidence that the naked CDS positions can significantly improve the diversification of broad portfolios, a major motivation for active trading in thess instruments. Specifically, we find that risk adjusted portfolios with CDS positions outperform portfolios of standard assets by up to 30% for a logarithmic utility maximizing investor. In addition, our tests show that cumulative portfolio turnover is lower for all weekly, monthly and quarterly rebalancing strategies when CDS positions are included. An important implication is that the booked return on CDS positions from 2004 to 2010 seem not be replicable by combinations of other assets in the market.

Credit Default Swaps: So Dear to Us, So Dangerous

This paper was written in November 2008 - two months after Lehman Brothers filed for bankruptcy and immediately triggered the financial crisis: The credit-default swap (CDS) is a type of financial tool that has created system-wide benefits. These derivative contracts, however, have also created the potential for relatively few market participants to destabilize the entire economic system. This Paper will explore (1) how CDS could hypothetically create systemic risk, (2) how CDS have recently exacerbated the current financial crisis, and (3) how the U.S. legislature could best regulate CDS to minimize systemic risk in the future. In theory, CDS could foster systemic crisis by means of (1) encouraging the growth of dangerous asset bubbles, (2) causing the collapse or failure of an institution that is systemically significant, or (3) creating perverse incentives that subvert policies underpinning business law on a system-wide scale. This Paper will question whether, with respect to the first theoretical risk, CDS have helped support the growth of the sub-prime mortgaged-backed securities asset bubble that has been blamed as the ultimate basis of the current financial crisis. Ultimately, there is evidence cutting both ways, thereby encouraging further research into the issue. That said, the second of these theoretical risks has certainly come into realization within the last few months when the trillion-dollar company, AIG, nearly destroyed itself by blundering in the CDS market and causing system-wide instability. As for the third theoretical risk, there is currently no empirical evidence that CDS create perverse incentives on a system-wide scale. How should the government regulate CDS to minimize systemic risk? After examining seven distinct proposals, this Paper (modestly) proposes that legislators require CDS market participants to (1) maintain increased capital reserve requirements when involved in the purchase or sale of CDS tied to highly speculative debt; and (2) confidentially disclose their CDS positions to the Federal Reserve. Increasing the capital reserve requirements for companies that trade in junk-grade CDS is essential for two reasons. First, higher capital reserve requirements protect the solvency of systemically significant institutions that attempt to profit from the riskiest CDS. Second, specifically targeting CDS that are associated with the junk lending business will discourage banks from extending cheap credit to unworthy borrowers, thereby reducing the potential for markets to generate precarious asset bubbles. As a second regulatory measure, confidential disclosure of CDS positions to the Federal Reserve is an efficient but relatively non- intrusive way to greatly facilitate the monitoring of systemic risk going forward. While the proposed legislative action would invariably impose costs on both market participants and society in general, the benefits of enhanced economic stability are incalculable.