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Credit Default Swaps, Fire-Sale Risk, and the Liquidity Provision in the Bond Market

Published online by Cambridge University Press:  29 June 2023

Massimo Massa  and
Lei Zhang Open the ORCID record for Lei Zhang [Opens in a new window]
Massimo Massa
Affiliation:
INSEAD Finance Department massimo.massa@insead.edu
Lei Zhang*
Affiliation:
City University of Hong Kong College of Business Department of Economics and Finance
*
lzhan29@cityu.edu.hk (corresponding author)
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Abstract

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We study the effect of credit default swaps (CDSs) on the bond market. Using a comprehensive sample of U.S. corporate bonds, we document that the presence of CDSs significantly increases bond liquidity and reduces yield spreads for investment grade bonds. We show that CDSs influence the bond market by lowering the impact of fire sales of institutional bondholders and facilitating inventory management for bond dealers who absorb fire sale shocks. However, the liquidity provision role of CDSs gets weakened after the CDS Big Bang in 2009, potentially because of the requirement of large upfront payments.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 4 , June 2024 , pp. 1963 - 1996
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank Joshua Coval, Madhu Kalimipalli, Martin Oehmke, Wenlan Qian, and conference participants at the Western Finance Association 2013 Meeting, the 2013 Singapore Scholars Symposium, and the 2014 SAIF-Moody Credit Market Meeting for their helpful comments and discussions. We thank Hendrik Bessembinder (the editor) and William Maxwell (the referee) for their comments that significantly improved the paper. All remaining errors and omissions are our own.

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