The Journal of Finance

Are CDS Auctions Biased and Inefficient?

Published: 06/21/2017   |   DOI: 10.1111/jofi.12541

SONGZI DU, HAOXIANG ZHU

We study the design of credit default swaps (CDS) auctions, which determine the payments by CDS sellers to CDS buyers following defaults of bonds. Using a simple model, we find that the current design of CDS auctions leads to biased prices and inefficient allocations. This is because various restrictions imposed in CDS auctions prevent certain investors from participating in the price discovery and allocation process. The imposition of a price cap or floor also gives dealers large influence on the final auction price. We propose an alternative double auction design that delivers more efficient price discovery and allocations.

Nonfundamental Speculation Revisited

Published: 08/01/2017   |   DOI: 10.1111/jofi.12548

LIYAN YANG, HAOXIANG ZHU

We show that a linear pure strategy equilibrium may not exist in the model of Madrigal (1996), contrary to the claim of the original paper. This is because Madrigal's characterization of a pure strategy equilibrium omits a second‐order condition. If the nonfundamental speculator's information about noise trading is sufficiently precise, a linear pure strategy equilibrium fails to exist. In parameter regions where a pure strategy equilibrium does exist, we identify a few calculation errors in Madrigal (1996) that result in misleading implications.

Benchmarks in Search Markets

Published: 06/01/2017   |   DOI: 10.1111/jofi.12525

DARRELL DUFFIE, PIOTR DWORCZAK, HAOXIANG ZHU

We characterize the role of benchmarks in price transparency of over‐the‐counter markets. A benchmark can raise social surplus by increasing the volume of beneficial trade, facilitating more efficient matching between dealers and customers, and reducing search costs. Although the market transparency promoted by benchmarks reduces dealers' profit margins, dealers may nonetheless introduce a benchmark to encourage greater market participation by investors. Low‐cost dealers may also introduce a benchmark to increase their market share relative to high‐cost dealers. We construct a revelation mechanism that maximizes welfare subject to search frictions, and show conditions under which it coincides with announcing the benchmark.