Essays on credit default swaps and debtor-creditor relationships

Abstract

Over the last decade, markets for credit insurance have developed dramatically and credit default swaps (CDS) have become the instrument of choice when it comes to hedging credit risks. The expanded hedging opportunities CDS provide and the allied benefits of better risk-sharing notwithstanding, concerns over the economic role of CDS arise from their ability to engender “empty” creditors – joint holders of the bond and CDS, and the role such creditors play in distress situations. Financially distressed firms often restructure their debt through out-of-court renegotiations with creditors to avoid formal default. In addition to the going concern value of the firm’s assets, the balance of bargaining power between the debtor and creditors plays a critical role in determining the success of these renegotiations, and therefore affects the preservation of economic value within the firm. When creditors partially or fully hedge their economic exposure to the debtor in the CDS markets, it alters the balance of bargaining power in debtor-creditor relationships. Scholars propose that CDS may strengthen creditors’ bargaining power in renegotiations and lead to frictions in debt renegotiations that may create both costs and benefits. However, the empirical evidence on the economic role of CDS in debt renegotiations is scarce and sometimes conflicting. In this dissertation, we analyze the influence of empty creditors on debtor-creditor relationships both from an ex-ante and ex-post perspective.