Credit Default Swaps and Cost Stickiness

Abstract

This paper investigates whether the initiation of credit default swaps (CDSs) on a reference firm’s outstanding debt is associated with a decline in that firm’s degree of cost stickiness. Like an insurance protection for creditors, CDSs contracts shift the bargaining power from borrowers to creditors, inducing creditors to be tough in debt renegotiation. Anticipating more intransigent lenders in debt renegotiations, borrowers may have heightened incentives to retain less excess resources when demand decreases in order to increase liquidity and avoid triggering debt covenants violations. Using the initial trading of Credit Default Swaps as a quasi- experiment setting, we find that the inception of CDSs trading is associated with a significant decline in reference firm’s degree of cost stickiness. This result remains robust after using propensity score matched method and instrumental variable approach to control for potential endogeneity problems. Furthermore, the mitigation effect of CDSs trading on the degree of cost stickiness is more pronounced for firms with higher financial constraints and higher refinancing risks. Collectively, our findings suggest that the CDSs-induced “empty creditor problem” causes reference firms more concerned about debt repayment, strengthening their incentives to increase liquidity and to reduce the likelihood of debt covenant violations.