Two New Studies about CDS Auctions [PDF]

As ISDA set the date for Greek CDS auction on March 19, my research discovered two new university studies, which discuss the credit default swap settlement auctions. The PDF papers were published in late 2011 and come from Stanford University, London Business School and London School of Economics. The first study wonders whether CDS auctions are biased and finds that the one-sided design of CDS auctions used in practice gives CDS buyers and sellers strong incentives to distort the final auction price, in order to maximize payoffs from existing CDS positions. The second study reveals that auctions undervalue bonds by an average of 10% on the auction day and suggests modifications to minimize the mispricing of the fair bond price.

Du and Zhu of Stanford University concluded in their “Are CDS Auctions Biased?” study that CDS auctions tend to overprice defaulted bonds conditional on an excess supply and underprice defaulted bonds conditional on an excess demand. They propose a double auction to mitigate this price bias.

The conclusion of Chernov, Gorbenko and Makarov who conducted the second study about CDS Auctions says:

We present a theoretical and empirical analysis of the settlement of CDS contracts when a credit event takes place. A two-stage, auction-based procedure aims to establish a reference bond price for cash settlement and to provide market participants with the option to replicate a physical settlement outcome. The first stage determines the net open interest (NOI) in the physical settlement and the auction price cap (minimum or maximum price, depending on whether the NOI is to sell or to buy). The second stage is a uniform divisible good auction with a marginal pro-rata allocation rule that establishes the final price by clearing the NOI.

In our theoretical analysis, we show that the auction may result in either overpricing or underpricing of the underlying bonds. Our empirical analysis establishes that the former case is more prevalent in practice. Bonds are underpriced by 10% on average, and the amount of underpricing increases with the NOI (normalized by the notional amount of deliverable bonds). We propose introducing a pro-rata allocation rule and a conditional price cap to mitigate this mispricing.

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