Price Discovery Limits in the Credit Default Swap Market in the Financial Crisis

We derive the credit default swap (CDS) premium a financial institution requires to assume the default risk of fixed income instruments and the maximum premium a CDS buyer is willing to offer. These premiums are functions of the institution’s capital and current risk 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 CDS premiums. Consistent with this, prior to the 2008 financial crisis credit default swap issuance increased substantially, as did the volume of the underlying mortgage-backed securities, but the data suggests that required CDS premiums remained constant or declined.