Economic Consequences of Speculative Side Bets: The Case of Naked Credit Default Swaps

Title
Economic Consequences of Speculative Side Bets: The Case of Naked Credit Default Swaps
Authors
Che, Yeon-KooSethi, Rajiv
Issue Date
2010-08-06
Series/Report no.
KDI Working Paper Series;WP11-01
Abstract
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.
URI
http://archives.kdischool.ac.kr/handle/11125/17282
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