Sovereign Debt and CDS - A Welfare Analysis

This paper presents a model of government borrowing, where the lender can insure himself against government default by signing a contract with a third party. Under quite general specifications I characterize the sub-game perfect equilibrium and compare it to the second-best and an economy where no such insurance is available. I find that under risk-neutrality of all parties the lender always chooses the efficient level of credit insurance and credit insurance is thus welfare improving compared to an economy without credit insurance. This is however no longer true in the case of risk-aversion of the government. I provide precise conditions under which an economy with credit insurance is strictly pareto-inferior compared to an economy without credit insurance.