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Did CDS Trading Improve the Market for Corporate Bonds?

by Sanjiv Das of Santa Clara University,
Madhu Kalimipalli of Wilfrid Laurier University, and
Subhankar Nayak of Wilfrid Laurier University

August 24, 2011

Abstract: Financial innovation through the creation of new markets and securities impacts related markets as well, changing their efficiency, quality (pricing error) and liquidity. The credit default swap (CDS) market was undoubtedly one of the salient new markets of the past decade. In this paper we examine whether the advent of CDS trading was beneficial to the underlying secondary market for corporate bonds. We employ econometric specifications that account for information across CDS, bond, equity, and volatility markets. We also develop a novel methodology to utilize all observations in our data set even when continuous daily trading is not evidenced, because bonds trade much less frequently than equities. Using an exhaustive sample of CDS and bond trades over 2002-2008, we find that the advent of CDS was largely detrimental - bond markets became less efficient, evidenced greater pricing errors and experienced lower liquidity. These findings are robust to various slices of the data set and specification of our tests.

JEL Classification: G10, G14.

Keywords: CDS, bond market efficiency.

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