Credit Default Swaps and Debt Contracts: Spillovers and Extensive Default Premium Choice

Abstract

This paper highlights two new effects of credit default swap (CDS) markets on credit markets. First, when firms' cash flows are correlated, CDS trading impacts the cost of capital and investment for all firms, even those that are not CDS obligors. Second, CDSs generate a tradeoff between default premiums and default risk. CDSs alter firm incentives to invest along the extensive default premium margin, even absent maturity mis-match. Firms are more likely to issue safe debt when default premiums are high and vise versa. The direction of the tradeoff depends on whether investors use CDSs for speculation or hedging.