Economic Consequences of Speculative Side Bets: The Case of Naked Credit Default Swaps
- Economic Consequences of Speculative Side Bets: The Case of Naked Credit Default Swaps
- Che, Yeon-Koo; Sethi, Rajiv
- Issue Date
- Series/Report no.
- KDI Working Paper Series;WP11-01
- We examine the e ects of \naked" credit default swaps on equilibrium debt contracts,
project choice, and the likelihood of default when investors have heterogeneous
beliefs about the future revenues of the borrower. Although such contracts are zero
sum side bets, their existence can have important economic consequences. They induce
investors who are most optimistic about the future revenues of borrowers, and would
therefore be natural purchasers of debt, to sell credit protection instead. This diverts
their capital away from potential borrowers and channels it into collateral to support
speculative positions. The resulting shift in the terms of lending against borrowers
can cause some projects with positive net present value to remain unfunded, or (in
the presence of agency problems) to be replaced by riskier projects with negative net
present value. It can also result in an increased likelihood of default and the selection
of equilibria in which rollover risk is ampli ed. The e ciency e ects of such contracts
are generally ambiguous and belief-dependent, although we identify circumstances in
which they result in an unambiguous e ciency loss.
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