CDS, Borrowing Costs, and Investment: Spillovers from Speculation and Financial Innovation

Abstract

This paper highlights two new effects of credit default swap (CDS) markets in a general equilibrium setting. First, CDSs affect firms' ex ante decision to issue defaultable debt. Specifically, firms choose between two debt contracts to finance investment--a safe debt claim that is repaid in all states, and a risky debt claim that defaults in some states. The safe debt contract requires issuing fewer bonds and investing less to ensure repayment in bad states. Issuing risky bonds maximizes profits in good states at the expense of default in bad states. CDSs alter the cost of issuing risky debt, which affects the opportunity cost of issuing safe debt. When CDS buyers hedge (speculate on) credit risk, CDSs lower (raises) credit spreads and increase (decrease) the likelihood that firms choose to issue risky debt. Second, when firms' cash flows are correlated, CDSs impact the cost of capital–credit spreads–and investment for all firms, even those that are not CDS reference entities.