Modeling optimal strategies in CDS markets: The role of creditor-issuer dynamics

We develop a model to analyze the optimal strategies of creditors and CDS issuers. By establishing conditions that ensure the reservation price of creditors exceeds that of the issuers, we demonstrate the existence of a CDS market. The difference between these reservation prices, influenced by factors such as risk aversion and fundamental uncertainty, plays a crucial role in shaping CDS market dynamics. We find that the issuer's reservation price increases with the size of their equity position in the reference-entity, and decreases with the diversity of the issuer's credit-risk portfolio. These findings have implications for the optimal design of CDS markets.