Synthetic or Real ?

We provide a model of non-redundant credit default swaps (CDSs), building on the observation that CDSs are more liquid than bonds. CDS introduction involves a trade-o↵: It crowds out demand for the bond, but improves the bond allocation because it allows long-term investors to become levered basis traders. CDS introduction raises bond prices only when there is a significant liquidity di↵erence between bond and CDS (both across and within firms). Our framework predicts a negative CDS-bond basis, turnover and price impact patterns that are consistent with empirical evidence, and shows that a ban on naked CDSs can raise borrowing costs. ⇤For helpful comments and suggestions, we thank Jennie Bai, Patrick Bolton, Willie Fuchs, Haitao Li, Xuewen Liu, Konstantin Milbradt, Suresh Sundaresan, Dimitri Vayanos, and Haoxiang Zhu, as well as conference and seminar participants at the 2013 Red Rock Conference, 2014 AFA Annual Meeting (Philadelphia), Boston University, Brandeis University, BIS, Vienna GSF, Singapore Management University, Nanyang Technological University, National University of Singapore, HKUST, Humboldt Universität zu Berlin, Columbia University, Michigan State University, Wharton, the Boston Fed, the 2014 SFS Calvacade, LSE, and the 2014 WFA. †Columbia Business School, 420 Uris Hall, 3022 Broadway, New York, NY 10027, e-mail: [email protected], http://www0.gsb.columbia.edu/faculty/moehmke ‡Boston University School of Management, 595 Commonwealth Avenue, Boston, MA 02215, e-mail: [email protected], http: //www.people.bu.edu/zawa