Sovereign debt renegotiation and credit default swaps |
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| Affiliation: | 2. Federal Reserve Bank of Philadelphia, Philadelphia, PA, United States;3. University of Pennsylvania, Philadelphia, PA, United States;4. University of Notre Dame, Notre Dame, IN, United States;1. School of Accounting, David Eccles School of Business, University of Utah, Salt Lake City, Utah 84112, USA;2. Department of Economics, The University of Warwick and OFCE-SciencesPo, The Social Sciences Building, Coventry, West Midlands CV4 7AL, United Kingdom |
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| Abstract: | A credit default swap (CDS) contract provides insurance against default. This paper incorporates the contract into a sovereign default model and demonstrates that the existence of a CDS market results in lower default probability, higher debt levels, and lower financing costs for the country. Uncertainty over the insurance payout when the debt is renegotiated explains why in the data, as the output declines, the CDS spread becomes lower than the bond spread. Finally, my results show that the 2012 CDS naked ban, that decreased the levels of CDS for European countries, is a welfare reducing policy. |
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