Mastering the metropolis through research and thought leadership.
Working Papers

Price Discovery in the Credit Markets

Working paper #805
Andrey Pavlov, Eduardo Schwartz and Susan M. Wachter

We derive the optimal credit default swap premium a financial institution requires to assume the
default risk of fixed income instruments. This premium is a function of the institution’s capital
and current exposure. In most cases, an institution requires an increasing premium to assume
additional risk. However, we show that an under-capitalized institution that already has
substantial default risk exposure would engage in risk-shifting and assume more risk at lower
rates. In other words, the presence of a financial institution with large default risk exposure in the
market reduces the premium required to insure additional risk. Therefore, negative signals about
the default risk of the debt instruments may vastly increases the quantity of insured instruments
with no effect on insurance premium. In fact, default insurance premiums decline in the face of
increasing demand. Consistent with this, prior to the recent financial crisis, the credit default
swap issuance increased greatly, as did the volume of the underlying nontraditional mortgages,
but the data suggests that required premiums stayed constant or declined.

Download full paper · 1MB PDF


In This Section
Explore Topics

1010 Affordable Housing Amazon Amenitization Architecture Artificial Intelligence Asia Australia automation Autonomous Vehicles bonds Borrowing Constraints Brexit California Canada Capital Business China Co-Working Environment coastal markets cold storage Colombia Commercial Brokerage Commercial Real Estate commissions Congestion consumer bias covid-19 CRE credit card market Credit Default Swaps Credit Insurance Credit Risk Transfers Culture Data Analytics data centers Data Collection Technology Debt Market Demand Demographics Density Development Discrete Choice disruption Diversity drones e-Commerce Economic Corridors economic policy economics education election studies Equity Funds Equity Market Ethnic Factors Europe Fannie Mae financial asset management Foreclosures Foreign Policy France Freddie Mac general equilibrium Global global economy Global Financial Crisis Globalization great depression Great Recession healthy buildings Hedonic hospitality Housing & Residential housing boom Housing Disease housing prices Housing Supply Identity Income Inequality India inflation Inter-generational mobility interest rates Investing jobs labor market Lagging Regions land use regulation Language life sciences Macroeconomics malls Market Pricing megacities Microeconomics Migration Minimum Payments Mixed-Use Mobility moral hazard mortgage insurance mortgage market Mortgage Rates Mortgages Multi-family Nation Building Non-Traditional Mortgages Office Market office sector pension funds Placed Based Policies Political Risk Price Discovery Private Equity Business public health public policy Public Schools real estate brokerage Real Estate Investment Real Estate Investment Trusts Recession Rental Retail Retirement reverse mortgages Risk Adjustment risk management risk-shifting robotics single family housing Slums Sorting South America Spatial Regions spillover effect stimulus package Sub-Prime Mortgages Sustainability Technology telecommunications trade transportation unemployment United States Urban Urbanization Warehouse welfare work from home

arrow_drop_up