Credit Default Swaps Trading Research Articles

Credit Default Swaps and Debt Overhang

We analyze the impact of credit default swaps (CDS) trading on firm investment, long-term debt financing, and valuation. In our model, the firm is endowed with a real option to initiate a project and enhance its future growth. Its creditors have access to CDS contracts that hedge them against default losses. We show that CDS protection increases the firm's pledgeable income, that is, the maximum amount of debt it can raise. However, at the same time CDS protection decreases asset growth and impedes project initiation. As a result, CDS trading could reduce firm value, and the negative effects are stronger when the firm is riskier, where shareholders have stronger bargaining power, and growth opportunities are less valuable. Using simulated cross-sections of firms, we find that CDS trading increases corporate default rates and deters investment. Altogether, CDS firms tend to have a lower firm value and more volatile equity returns than non-CDS firms.

Credit Default Swaps and Earnings Management

In this study, we examine the association between the initiation of credit default swaps (CDS) trading and firms’ earnings management behavior. Since CDS contracts help creditors transfer credit risk, creditors tend to be tough in debt renegotiations. Anticipating tough creditors, CDS firms may be forced to manage earnings upward to avoid debt renegotiations rather than deflate earnings to extract covenant claim concessions from creditors. Consistent with our expectation, we find that the introduction of CDS trading is positively associated with firms’ income-increasing discretionary accruals. Our findings remain robust after we control for the endogeneity of CDS trading using the propensity-score matching method, the placebo test, and the two-stage instrumental variable approach. Furthermore, we find that the positive association between CDS initiation and discretionary accruals is more pronounced for firms with tighter financial constraints and poorer information environment. We also find that CDS initiation is negatively associated with firms’ real earnings management activities, suggesting that firms substitute the less costly accrual-based earnings management for the more costly real earnings management after CDS-initiation. Overall our study suggests that firms respond to the “empty creditor problem” created by CDS trading through earnings management tools.

Credit default swaps, exacting creditors and corporate liquidity management

We investigate the liquidity management of firms following the inception of credit default swaps (CDS) markets on their debt, which allow hedging and speculative trading on credit risk to be carried out by creditors and other parties. We find that reference firms hold more cash after CDS trading commences on their debt. The increase in cash holdings is more pronounced for CDS firms that do not pay dividends and have a higher marginal value of liquidity. For CDS firms with higher cash flow volatility, these increased cash holdings do not entail higher leverage. Overall, our findings are consistent with the view that CDS-referenced firms adopt more conservative liquidity policies to avoid negotiations with more exacting creditors.

You Blinked: The Role and Incentives of Managers in Increasing Corporate Risks Following the Inception of Credit Default Swap Trade

Prior studies show that a lender’s incentive to monitor a client’s activities declines after receiving insurance on its loan via a credit default swap (CDS). We examine whether this altered debtor-creditor relation affects borrowers’ investment activities. We hypothesize that the borrower enhances activities that were previously constrained by lender monitoring. It shifts from safe to risky assets to increase the value of call options built into shareholder investments. We do not find support, on average, for this proposition. However, when managers’ wealth increases convexly with firm assets, borrowers increase risky investments and dividend payouts after the onset of CDS trading.

A HEALTHY DOSE OF PESSIMISM? INFLUENCE OF THE UKRAINIAN ECONOMY ON ITS BANKING SECTOR CREDIT RATINGS

The purpose of the research is to identify the influence of Ukraine’s economic development on the international agencies' credit rating of its banking system. The instability and ambiguous geopolitical position of Ukraine are complicating any predictions for its economic developments. In the meanwhile, massive restructuring of all sectors of the economy became the necessary minimum for the reformation of the country and the achievement of the international standards. It is interesting to see how exactly these international standards, as represented by the evaluation of the rating agencies, appraise Ukraine, and particularly its banking sector. The methodology involves the analysis of the three major Ukrainian banks – PrivatBank, Oschadbank, and Ukreximbank using Fitch’s credit quality assessment systematic as an example. The comparative analysis was performed using Tier 1 capital ratio and loan-to-deposit ratio of these banks, year-to-year quarterly GDP growth, consumer price index (CPI) year-to-year change, UAH/USD exchange rate, 2-year and 5-year government bond yield, as well as 2-year and 5-year credit default swap (CDS). Results show that the most influential credit rating drivers for Ukrainian banks are: exchange rate; funding and liquidity; capital position and asset quality; sovereign risk. The research showed that the 2-year and 5-year government bond yield in USD and 2-year and 5-year CDS were influenced by similar trends. The yield on short-dated Ukrainian governmental bonds has shown a parallel increase with the corresponding CDS that indicated the market’s evaluation of the stressed condition of the country’s government and economy. Additionally, conventional yield structures displayed inversed nature with 2-year governmental bond yield in USD trading at significantly higher yields than 5-year government bond yield in USD during times of economic distress. Although longer maturity instruments should usually trade at a higher rate, such a development could have reflected the public markets’ scepticism to the Ukrainian government’s short-term solvency. The closer look at the Tier 1 capital ratio, which is considered to be a key indicator of the financial health of the banks, revealed analogy between it and three major Ukrainian banks rating development, indicating the Tier 1 capital ratio as a strong influencing factor. Loan-to-deposit ratio as an indicator of bank liquidity moved in parallel with decreasing credit ratings. The strong decrease in the UAH/USD exchange rate mirrored a strong increase in inflation and overall worsening state of the Ukrainian economy also being reflected in the major banks’ ratings. Practical implications. The correlation of these factors is relevant for bank managers and investors who can use financial market indicators to forecast and plan their own ability to conduct business. Likewise, academic researchers can further build on this study to add to the literature on country-specific reviews of sovereign debt crises and their impact on national banking systems. Value/originality. This research demonstrates that a worsening of financial indicators of the health of Ukraine’s financial system as measured by government bond yields and the trading of credit default swaps, as well as the country’s economic downturn, go along with a decline of local banks’ credit ratings.

Empty Creditors and Strong Shareholders: The Real Effects of Credit Risk Trading

Credit derivatives give creditors the possibility to transfer debt cash flow rights to other market participants while retaining control rights. We use the market for credit default swaps (CDSs) as a laboratory to show that the real effects of such debt unbundling crucially hinge on shareholder bargaining power. We find that creditors buy more CDS protection when facing strong shareholders to secure themselves a valuable outside option in distressed renegotiations. After the start of CDS trading, the distance-to-default, investment, and market value of firms with powerful shareholders drop by 7.9%, 7%, and 8.8% compared to other firms.

Why Do Investors Buy Sovereign Default Insurance?

We provide a comprehensive analysis of the determinants of trading in the sovereign credit default swaps (CDS) market, using weekly data for single-name sovereign CDS from October 2008 to September 2015. We describe the anatomy of the sovereign CDS market, derive a law of motion for gross positions and their components, and identify the key factors that drive the cross-sectional and time-series properties of trading volume and net notional amounts outstanding. While a single principal component accounts for 54 percent of the variation in sovereign CDS spreads, the largest common factor explains only 7 percent of the variation in sovereign CDS net notional amounts outstanding. Moreover, unlike for CDS spreads, common global factors explain very little of the variation in sovereign CDS trading and net notional amounts outstanding, suggesting that it is driven primarily by idiosyncratic country risk. We analyze several local and regional channels that may explain the trading in sovereign CDS: (a) country-specific credit risk shocks, including changes in a country's credit rating and related outlook changes, (b) the announcement and issuance of domestic and international debt, (c) macroeconomic sentiment derived from conventional and unconventional monetary policy, macro-economic news and shocks, and (d) regulatory channels, such as changes in bank capital adequacy requirements. All our findings suggest that sovereign CDS are more likely used for hedging than for speculative purposes.

Credit derivatives and stock return synchronicity

The role of credit default swaps (CDS) in the 2008 financial crisis has been widely debated among regulators, investors, and researchers. While CDS were blamed for destabilizing the financial system, they remain effective tools for hedging credit risk, especially for major banks, and produce positive informational externalities to market participants. This paper examines whether the introduction of CDS enhances the amount of firm-specific information impounded in stock prices. We use stock return synchronicity to measure the amount of firm-specific information reflected in stock prices, with more firm-specific information being associated with a lower level of synchronicity. We find that a firm’s stock return synchronicity decreases after the commencement of CDS trading. This finding is robust to different model specifications, synchronicity measures, and endogeneity controlling methodologies. Furthermore, the decrease in stock return synchronicity is more pronounced for CDS firms with higher credit risk. Overall, our evidence supports the positive role of CDS in improving informativeness of stock prices.

Does the Onset of CDS Trading Increase Tax Avoidance?

Credit default swaps (CDS), provide protection against borrowers’ adverse credit events, potentially reducing lenders’ incentives to diligently monitor their creditors. In this study, we examine whether this reduction in lender monitoring induces greater corporate tax avoidance by borrowers. Using a difference-in-differences approach that exploits the variation in dates of the onset of CDS trading, we document that borrowers exhibit greater tax avoidance following the onset of CDS trading. Additionally, we find the observed effect to be stronger when lenders’ reputation costs in the event of a borrower default are lower. The effect is also more pronounced when ex-ante shareholder-manager agency conflicts are greater, suggesting that increased post-CDS tax avoidance is likely an outcome of managerial rent extraction as opposed to asset substitution. Additional analyses reveal that the observed effect is stronger for firms that are informationally opaque and financially constrained. Our study provides the first evidence on a potentially unintended effect of CDS trade initiation on corporate tax policies.

My Credit But Your Problem: The Real Effects of Credit Risk Trading

Credit derivatives give creditors the possibility to transfer debt cash flow rights to other market participants while retaining control rights. We use the market for credit default swaps (CDSs) as a laboratory to show that the real effects of this transfer crucially hinge on the relative bargaining power of shareholders and creditors. We find that creditors buy more CDS protection when facing strong shareholders to secure themselves a valuable outside option in distressed renegotiation. After the start of CDS trading, the distance-to-default, investment, and market value of firms with powerful shareholders decline substantially relative to other firms.

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

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.

Liquidity and Pricing of Credit Default Swaps in Japan: Evidence from a Benchmark Index for Corporate Debt Claims

This article is a contribution towards the growing empirical literature on the relationship between liquidity and pricing of credit default swaps (CDSs). To the best of my knowledge, the article becomes the first to show that market liquidity does matter to CDS pricing in Japan, by looking into a sole benchmark index of CDS trading for investment-grade debt claims, or the Markit iTraxx Japan (MiJ). The impact of illiquidity on MiJ premia has declined since the International Swaps and Derivatives Association introduced new trade practices in April 2009. The liquidity of the MiJ has increased since the Japan Securities Clearing Corporation started operating as a central counterpart for the MiJ in July 2011. The price discovery ability of the MiJ has also increased since then.

The leverage externalities of credit default swaps

This paper provides the first empirical evidence of the externalities of credit default swaps (CDS). We find that a firm's leverage is lower when a larger proportion of its revenue is derived from CDS-referenced customers. This finding is robust to alternative samples and measures, placebo tests, and the selection of customers by suppliers. Moreover, firms affected by customer CDS trading issue equity to lower leverage, and their equity issuance costs are lower. These findings are consistent with the view that CDS trading on customers improves the information environment for suppliers. Therefore, while many firms are not directly linked to CDS trading, CDS trading on their customers has spillover effects on these firms’ financial policies.

Credit Derivatives and Analyst Behavior

ABSTRACT This paper presents a comprehensive analysis of the role of credit default swaps (CDS) in information production surrounding earnings announcements. First, we demonstrate that the strength of CDS price discovery prior to earnings announcements is related to the presence of private information and the illiquidity of the underlying corporate bonds, consistent with the CDS market being a preferred venue for informed trading. Next, we ask how the information revealed through CDS trading influences the output of equity and credit rating analysts. We find that post-CDS trading, the dispersion and error of earnings per share forecasts are generally reduced, and downgrades by both types of analysts become more frequent and more timely before large negative earnings surprises, suggesting that the CDS market conveys information valuable to financial analysts.

Credit Default Swaps, Exacting Creditors and Corporate Liquidity Management

We investigate the liquidity management of firms following the inception of credit default swaps (CDS) markets on their debt, which allow hedging and speculative trading on credit risk to be carried out by creditors and other parties. We find that reference firms hold more cash after CDS trading commences on their debt. The increase in cash holdings is more pronounced for CDS firms that do not pay dividends and have a higher marginal value of liquidity. For CDS firms with higher cash ow volatility, these increased cash holdings do not entail higher leverage. Overall, our findings are consistent with the view that CDS-referenced firms adopt more conservative liquidity policies to avoid negotiations with more exacting creditors.

Credit Derivatives and Earnings Announcements

This paper presents a comprehensive analysis of the role of credit default swaps (CDS) in information production surrounding earnings announcements. First, we demonstrate that the strength of CDS price discovery prior to earnings announcements is related to the presence of private information and the illiquidity of the underlying corporate bonds, consistent with the CDS market being a preferred venue for informed trading. Next, we ask how the information revealed through CDS trading influences the output of equity and credit rating analysts. We find that post-CDS trading, the dispersion and error of earnings-per-share forecasts are generally reduced, and downgrades by both types of analysts become more frequent and more timely before large negative earnings surprises, suggesting that the CDS market conveys information valuable to financial analysts.

Credit Derivatives and Stock Return Synchronicity

This paper examines whether credit default swap (CDS) introduction enhances the amount of firm-specific information impounded in stock prices. We use stock return synchronicity to measure the amount of firm-specific information reflected in stock prices, with more firm-specific information being associated with a lower level of synchronicity. We find that a firm’s stock return synchronicity decreases after the commencement of CDS trading. This finding is robust to different model specifications, synchronicity measures, and endogeneity controlling methodologies. Furthermore, the decrease in stock return synchronicity is more pronounced for CDS firms with higher credit risk and better information environment.

When Is CDS Trading Innocuous?

Credit default swaps (CDS) are among the very few financial instruments that some regulators and practitioners want banned. We study whether and when CDS trading impacts bank lending. We first show that the bank CDS position is positively related to the portfolio borrower CDS market. Then we find that, overall, firms receive larger loans after they become CDS referenced. However, this is only the case when the lead bank is active in CDS trading. CDS-referenced borrowers do not obtain larger loans when their lead banks do not trade CDS. Stock returns are higher for CDS-using banks than for non-CDS banks in tranquil times but lower during crisis periods, suggesting that CDS can induce procyclicality in banking performance. Our findings demonstrate the critical role that bank lenders play in transmitting the real effects of CDS.

Active CDS Trading and Managerss Voluntary Disclosure

We investigate how the development of the credit default swap (CDS) market affects firms’ voluntary disclosure choices. The CDS market has been criticized, inter alia, for (i) its vulnerability to insider trading by informed lenders who trade on borrowers’ private information, and (ii) the reduction in lenders’ monitoring efficiency due to their ability to shed credit risk exposure via CDSs. Consistent with voluntary disclosure theory, we predict that informed trading by lenders and the consequent threat of private information revelation in the spreads of actively traded CDSs will pressure managers to enhance their voluntary disclosures to mitigate the risks associated with non-disclosure. Further, the reduction in lender monitoring will lead shareholders to intensify their own monitoring efforts and demand increased voluntary disclosures from managers. Consistent with these predictions, we find that managers are more likely to issue earnings forecasts and to forecast more frequently when their firms have actively traded CDSs. Our results also suggest that liquid CDSs discipline managers to disclose bad news earnings forecasts, despite their career- and wealth-related incentives to withhold adverse information. In addition to disclosure via management forecasts, we document that liquid CDSs also enhance disclosure via firm-initiated press releases. Our findings suggest that the allegedly negative attributes of the CDS market could result in a positive externality for capital markets by eliciting enhanced voluntary disclosures and thus contribute to a richer information environment.

The Impact of Credit Default Swap Trading on Loan Syndication *

We analyze the impact of credit default swap (CDS) trading on bank syndication activity. Theoretically, the effect of CDS trading is ambiguous: on the one hand, CDS can improve risk-sharing and hence be a more flexible risk management tool than loan syndication; on the other hand, CDS trading can reduce bank monitoring incentives. We document that banks are less likely to syndicate loans and retain a larger loan fraction once CDS are actively traded on the borrower’s debt. We then discern the risk management and the moral hazard channel. We find no evidence that the reduced likelihood to syndicate loans is a result of increased moral hazard problems.