Exploring the effects on competition of speculation over credit default swaps' spread: A theoretical framework for simulation modeling

In this work, I constructed a theoretical model of a competitive bond market with credit default swaps (CDS) trading as collaeral for one agents' debt. This model serves as the basis for simulations aimed at shedding light into certain phenomena associated with speculation in the credit derivatives market. First, a solid benchmark case was conducted, where a complete funding nash equilibrium (CFNE) was found. Then, the possibility to introduce CDS trading over the debt of one of the agents was added to the model, and more restricted theoretical results were obtained. Still, this extension proved useful as a foundation for several computational simulations that illustrate the equilibria. I present some examples of this. Particularly, taking an interest in the work of Flannery et al. (2010), which explored the possibility of using the CDS spread as a substitute for credit rating of the underlying asset, one of the simulations suggests that in such a case, there might be an incentive to set prices outside the equilibrium, thus affecting competition between agents.