Sovereign Default and Credit Swaps: The Role of Dealers’ Liquidity Provision

Résumé

We propose a model of sovereign default where investors trade bonds and credit default swaps (CDS) contracts of a country, with both assets being traded over the counter. We model the over-the-counter market with directed search, where dealers post the terms of trade and investors choose which dealer to go to. The model captures a main feature that the existing literature on CDS emphasizes. Namely, CDS act as an additional source of liquidity for investors. Our model highlights the role of dealers in providing liquidity, which reduces the liquidity premium of sovereign bonds, the cost of financing debt and, ultimately, default risk. We complement our theoretical study with an empirical analysis of the CDS position of the main traders in the sovereign CDS market. Finally, we calibrate our model to quantify the effect that the European ban on naked sovereign CDS had on default risk.