Faculty of Economics and Business Administration Publications Database

Credit derivatives, capital requirements and opaque OTC markets

Nicolo, Antonio
Volume: 17
Number: 4
Pages: 444 - 463
Month: October
ISSN-Print: 1042-9573
Link External Source: Online Version
Year: 2008
Keywords: Credit derivatives; Signaling contracts; Capital requirements

In this paper we study the optimal design of credit derivative contracts when banks have private information about their ability in the loan market and are subject to capital requirements. First, we prove that when banks are subject to a maximum loss capital requirement the optimal signaling contract is a binary credit default basket. Second, we show that if credit derivative markets are opaque then banks cannot commit to terminal-date risk exposure, and therefore the optimal signaling contract is more costly. The above results allow us to discuss the potential implications of different capital adequacy rules for the credit derivative markets.