ESSAYS ON THE INTERACTIONS BETWEEN CREDIT DEFAULT SWAP AND BOND MARKETS

This Ph.D. thesis consists of three research papers which are the result of my studies at the Lombardy Advanced School of Economic Research, University of Milan. Part of this work was accomplished during my visiting period at the Market Operations Analysis division at the European Central Bank. Abstract I: Since the issuance of the first credit default swap (CDS) contract in 1994, trading volume in CDS has been growing exponentially, transforming a niche market into a multi-trillion-dollar market. The subprime crisis in the US and the sovereign crisis in the EU contributed to raise concerns on the potential destabilising role of such an instrument. Thus, also the academic literature started to hotly debate the benefits and costs that trading in CDSs has on both the financial market and the real economy. The aim of this study is to review some segments of the literature on CDSs, and to identify existing gaps and room for further research. After discussing the features of CDSs and the relative welfare implications, we survey theoretical studies which model CDS pricing, empirical literature exploring the determinants of CDS spreads, and papers which study the relationship between CDSs and their underlying assets. Abstract II: This study performs two empirical analyses to address (i) whether credit default swaps (CDS) written on European banks lead the price of their underlying bonds and (ii) the implications of the leading role of the CDS market on the determinants of banks' credit risk. The results of the first analysis show that the CDS market leads bonds' prices for nearly half of the banks in our sample. To assess the impact of this phenomenon on banks' credit risk, the sample is split into two groups, and the explained part of CDS spread changes is decomposed according to various risk drivers. It is shown that the home country sovereign risk has a different impact on the two groups, revealing a stronger transaction mechanism of risk when the CDS market is in the lead. Abstract III: Using a continuous-time, stochastic, and dynamic framework, this study derives a closed-form solution for the optimal investment problem for an agent with hyperbolic absolute risk aversion preferences for maximising the expected utility of his or her final wealth. The agent invests in a frictionless, complete market in which a riskless asset, a (defaultable) bond, and a credit default swap written on the bond are listed. The model is calibrated to market data of six European countries and assesses the behaviour of an investor exposed to different levels of sovereign risk. A numerical analysis shows that it is optimal to issue credit default swaps in a larger quantity than that of bonds, which are optimally purchased. This speculative strategy is more aggressive in countries characterised by higher sovereign risk. This result is confirmed when the investor is endowed with a different level of risk aversion.