Working Paper: CEPR ID: DP12694
Authors: Sven Klingler; David Lando
Abstract: Credit Default Swaps can be used to lower capital requirements of dealer banks who enter into uncollateralized derivatives positions with sovereigns. We show in a model that the regulatory incentive to obtain capital relief makes CDS contracts valuable to dealer banks and empirically that, consistent with the use of CDS for regulatory purposes, there is a disconnect between changes in bond yield spreads and in CDS premiums especially for safe sovereigns. Additional empirical tests related to volumes of contracts outstanding, effects of regulatory proxies, and the corporate bond and CDS markets support that CDS contracts are used for capital relief.
Keywords: CDS premiums; capital charges; CVA; CDS-bond basis
JEL Codes: F34; G12; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Financial regulation (G18) | CDS premiums (G22) |
| Financial regulation (G18) | Notional amounts outstanding (G19) |
| Regulatory incentive for dealer banks (G28) | CDS contracts value (G19) |
| Regulatory factors (L51) | Disconnect between bond yield spreads and CDS premiums (G19) |
| Changes in CDS premiums (G19) | Bond yields for riskier sovereigns (F34) |
| Regulatory proxies (G18) | Variation in CDS premiums for safe-haven sovereigns (F34) |
| Credit risk (G21) | CDS premiums (G22) |