RT Journal Article
SR Electronic
T1 Mispricing and Arbitrage in CDS Auctions
JF The Journal of Derivatives
FD Institutional Investor Journals
SP 79
OP 91
DO 10.3905/jod.2015.22.4.079
VO 22
IS 4
A1 Sudip Gupta
A1 Rangarajan K. Sundaram
YR 2015
UL https://pm-research.com/content/22/4/79.abstract
AB Credit default swaps were a major addition to the array of financial instruments available in the market. But as is typical for a fundamentally new product, the early designs had to be tweaked. First, it was necessary to eliminate ambiguity over what constitutes a credit event, and more recent changes enhanced liquidity by standardizing the contract terms and regularized how the payoff is determined following a default. This is now accomplished through a rather complicated twostage auction process. In this article, Gupta and Sundaram describe how the auction works and establish the existence of a striking and somewhat troubling pattern exhibited by prices of the underlying bonds at the time of the auction. In auctions where the first round shows an imbalance of selling over buying orders, the market price is higher on the day prior to the auction, drops sharply at the auction, and then shoots upward the next day. The reverse pattern happens in a buy auction. These patterns produce significant profits for simple trading rules, such as buying (selling) immediately after a sell (buy) auction.TOPICS: Credit default swaps, exchanges/markets/clearinghouses