Credit Default Swaps Trading Research Articles

The real effect of CDS trading: Evidence from corporate employment

AbstractThis paper examines whether the inception of credit default swaps (CDS) trading curbs corporate employment. We show that firms with CDS trading have significantly lower employment growth. Our baseline results are robust to alternative measures of corporate employment growth, various approaches that mitigate endogeneity concerns due to omitted variables and reverse causality, and additional control variables. The decrease in firms' employment growth after CDS trading is more pronounced in firms with larger financial constraints and lower CEO risk‐taking. In addition, we find that the inception of CDS trading affects employment growth through the financial distress channel. Further analysis finds that the inception of CDS trading could mitigate the labor over‐investment problem, stimulating employment efficiency. Our evidence suggests that corporate employment growth is reduced after the initiation of CDS trading due to the heightened cost of defaults.

Sovereign debt and credit default swaps

How do credit default swaps (CDS) affect sovereign debt markets? We analyze how liquidity, exposure to default risk, and regulation affect the answer to this question using a sovereign debt model where investors trade bonds and CDS over the counter via directed search. Restricting portfolios can improve bond prices and bond-market activity, but the net effect depends on relative frictions in bond and CDS markets, the exposure of investors, and how the sovereign responds to the policy. Our novel identification strategy exploits confidential microdata to quantify trading frictions and the exposure distribution. The calibrated model generates realistic CDS-bond basis deviations, bid–ask spreads, and CDS volumes and positions. Our baseline specification predicts trading frictions and an inability to short sell bonds significantly improves sovereign debt prices, but policies that restrict CDS trading have small effects.

Market Liquidity in a Natural Experiment: Evidence from CDS Standard Coupons

Abstract The credit default swap (CDS) Big Bang introduced 2 standard coupons for CDS trading. We exploit the setting of the 2 standard coupons as a natural experiment to quantify the components of the bid–ask spreads in over-the-counter markets. We find that a significant portion of the difference in the bid–ask spread between the 2 coupons is explained by the difference in funding costs. Furthermore, search intensity also explains the variation in the difference in bid–ask spread. The liquidity typically concentrates on one of the standard coupons and can suddenly switch to the other coupon. Using the sudden switch of the primary coupon, we provide further evidence to support the predictions of search-based liquidity models.

Tournament incentives, credit default swaps trading, and corporate policies: The interplay of managerial and creditor incentives

This paper investigates how the interaction between managerial and creditor incentives affects corporate risk and policies. Using a sample of 16,513 firm-year observations from 2001 to 2014, we find that credit default swaps (CDS) trading leads to higher stock return volatility and leverage, yet lower cash flow volatility and capital expenditure. Meanwhile, tournament incentive is associated with higher firm risk and more aggressive corporate policies. Further, we find that the interaction between tournament incentives and CDS trading alleviates the overall effect of intra-firm tournament incentives and CDS trading on firm risk and corporate policies. Altogether, our results suggest that risk-averse managers balance risk-taking incentives and creditor incentives when making corporate decisions and, hence are less sensitive to tournament incentives due to their concerns about exacting empty creditors problems in CDS-referenced firms. This study contributes to the literature by providing initial insights into the interaction effects between managerial and creditor incentives.

Credit default swaps and corporate ESG performance

This study finds that credit default swap (CDS) trading positively affects a firm's environmental, social, and governance (ESG) performance. This effect is more prominent in ESG strengths than ESG concerns. The proposed empirical connection remains valid across endogeneity-controlling methodologies, model specifications, and ESG performance measures. The effect is stronger for firms with stronger bank relationships, higher debt dependence, and more restrictive covenants. Furthermore, improvement in ESG performance is more pronounced for firms with more free cash flow, lower institutional ownership, and higher financial constraints. Our findings reveal the real effects of CDS trading on firm ESG performance.

Credit default swaps and corporate debt structure

Whether and how credit default swaps (CDSs) affect corporate debt structure remains an unanswered question. We find that firms use more public debt relative to bank debt when CDSs referencing their debt start trading. The results are robust to the endogeneity of CDS trading. Furthermore, the increase in public debt is concentrated in senior bonds and notes, which are the most common CDS reference assets. The effect of CDS trading is most pronounced when bond underwriters take a net selling CDS position and for informationally opaque firms. These findings suggest that the hedging and informational roles of CDSs have real effects on corporate debt structure.

Credit default swaps and firm risk

AbstractThis study investigates how initiating a credit default swap (CDS) affects firm risk. Using the firm value volatility as a measure of firm risk, we document that firm risk decreases following the commencement of CDS trading. Further analysis indicates that the empty creditor channel, which arises when a debt holder with CDS protection has no interest in preserving the company it provides funds, is the primary way of influence. Our findings reveal a significant impact of financial innovation on a firm's behavior. We also document that market frictions affect the degree of such effect.

Does credit default swap trading improve managerial learning from outsiders?

AbstractWe investigate whether credit default swap (CDS) trading results in managers learning new information through stock prices that is relevant to their investment and forecasting decisions. We argue that the CDS market structure, the sophistication of CDS market participants, and the cleanness of CDS spreads as a signal of default risk together produce and convey information that is new to managers of firms referenced in CDS contracts. We consider two measures for managerial learning: (1) the sensitivity of managerial investments to share prices and (2) the sensitivity of changes in management forecast accuracy to stock returns. We find that both sensitivity measures increase significantly when firms are referenced in any traded CDS contracts, indicating that CDS trading improves managerial learning. We also find that the improvement in managerial learning is more pronounced for firms that are subject to higher uncertainty in industry‐specific and economy‐wide prospects, consistent with the view that CDS market participants have informational advantages with respect to the industry‐level and macroeconomic environments. We further find that the improvement in managerial learning is more evident for firms with higher credit risk. Our findings provide large‐sample evidence on a positive consequence of CDS trading in the context of managers' ability to learn from outside investors.

Pricing of Credit Default Swaps from the Perspective of Credit Enhancement in PPP Projects

The difficulty in financing has become the primary obstacle in the process of promoting a public–private partnership (PPP). Asset securitization is a financial model that can exchange the predictable cash flow of illiquid PPP project assets with the current cash flow, and credit enhancement is crucial in this process. Different from the traditional external credit enhancement of PPP projects based on government guarantees, this paper introduces an innovative credit risk management tool, i.e., credit default swaps (CDS), into the process of asset securitization in the PPP model. In order to avoid opportunistic behavior caused by information asymmetry in the process of financial product transaction, a CDS trading contract between PPP project investors and risk management institutions based on the principal–agent theory and a flexible CDS pricing model is proposed. Through a demonstration case of the Leshan to Rongjiang Expressway in China, the volatility correlation among CDS contract default probability, pricing, and related factors, such as default limits, operation period, compensation amount, project investment return, investment return volatility, and PPP project investors’ expected inputs, is obtained. The study shows that (1) appropriate CDS pricing helps to generate investors’ high expected inputs and diligence with controls; (2) there is a positive correlation between the change of default limit and compensation amount, and the set value of default limit should not be too high, otherwise it may induce the increase of default probability; and (3) based on the high return on assets and moderate asset volatility of PPP projects, the probability of default of CDS contracts is low. The innovative financial mechanism developed by the principal–agent theory could enrich the credit enhancement methods in asset securities of PPP projects.

Stock price informativeness and credit default swap trading

AbstractThis study develops a difference‐in‐differences analysis to assess whether trading onset of credit default swaps (CDS) on a firm's debt improves price informativeness in the stock market. Price informativeness is measured by the future earnings response coefficient, which captures the amount of information about future earnings conveyed in stock returns. Our sample comprises U.S. firms (firms experiencing CDS trading on their debt and a group of control firms) and covers the period 1997–2015. The results indicate that CDS hinder stock price informativeness, and thus the ability of prices to track long‐term fundamentals, especially before the arrival of negative information about the obligor. The identified impact is stronger when CDS are first traded, becoming less pervasive with the passage of time. Finally, the results indicate that effects were residual during the early stages of CDS market development and peaked during the period 2004–2008. The impact of CDS introduction weakened after new regulation and ISDA protocols entry into force in 2009. This empirical analysis contributes to the literature by improving knowledge on the consequences of CDS trading on economic and financial outcomes. It points out a negative effect on price informativeness in the stock market and indicates that it was smoothed by regulatory measures designed to improve market infrastructure and transparency.

Credit default swaps and debt specialization

We examine the effect of credit default swaps (CDSs) on debt specialization. We argue that reference firms in CDS contracts, seeking to minimize creditor conflicts and bankruptcy costs, exhibit higher debt concentration than firms on which no CDSs are traded. Our results show that firms engage in greater debt specialization and are more likely to specialize following the inception of CDS trading. Additionally, we find that, while lender concentration in firms increases, the number of bank lenders drops, lead arranger share rises, and the probability that lead arrangers and lenders are repeated increases following the onset of CDS trading. Our results are robust to instrumental variable estimation, propensity-score matching, different model specifications, and different subsamples.

The Effect of CDS Trading on Product Market Competition: Evidence from 10-K Filings

This paper examines how the initiation of credit default swap (CDS) trading affects the product market competition faced by the referenced firms in the US. The trading of CDS provides an avenue for creditors to hedge default risks, thereby weakening the incentives to monitor the borrowers. Our paper shows that the trading of CDS increases firm-level product market competition because a reduced creditor monitoring effect can lead to growing shareholder demand for information disclosure, revealing strategic information that may undermine the product market competency of the firm when disclosed. While prior literature shows that CDS-traded firms increase both the likelihood and frequency of earnings forecasts as a direct response to shareholder demand, we observe that firms made their mandatory disclosure (i.e., Form 10-K) less readable as a potential way to reduce strategic disclosure. We also find that the presence of institutional investors generally reduces a firm’s competition, but this positive effect is overturned in the presence of CDS trading.

The Inception of Credit Default Swap Trading and Corporate Cost Structure

ABSTRACTPrior literature shows that how creditors monitor borrowers and exercise control rights affect borrowers’ investment and financial policies, but little is known about their impact on borrowers’ operating decisions. The availability of a credit default swap (CDS) reduces creditors’ monitoring incentives ex ante but increases their liquidation incentives in the events of default ex post. After the inception of CDS trading, reference firms exhibit an increase in the elasticity of cost structure. Results are consistent in instrumental variable analyses and are robust with alternative matching samples. The increase in cost structure elasticity is more pronounced for firms with greater credit risk and more restrictive covenants and financially constrained firms, and those face greater product market competition and provide higher convexity in managers’ compensation. We provide the first evidence showing that managers choose a more elastic cost structure when creditors become less forgiving.Data Availability: All the data used in this paper are from publicly available databases.JEL Classifications: D24; G32; M41.

Withholding Bad News in the Face of Credit Default Swap Trading: Evidence from Stock Price Crash Risk

AbstractCredit default swaps (CDSs) are a major financial innovation related to debt contracting. Because CDS markets facilitate bad news being incorporated into equity prices via cross-market information spillover, CDS availability may curb firms’ information hoarding. We find that CDS trading on a firm’s debt reduces the future stock price crash risk. This effect is stronger in active CDS markets, when the main lenders are CDS market dealers with securities trading subsidiaries, or when managers have more motivation to hoard information. Our findings suggest that debt market financial innovations curtail the negative equity market effects of firms withholding bad news.

Impact of credit default swaps on firms’ operational efficiency

As one of the most important financial innovations in the last two decades, credit default swap (CDS) contracts have been initiated and actively traded in the market to hedge against credit risks. However, little is known about how these financial innovations affect an underlying firm's operations. In this empirical study, we find that an underlying firm's operational efficiency is significantly improved with the inception of CDS trading. Our results are robust to multiple causal identification strategies. Further analysis suggests that the inception of CDS tends to enhance the operational efficiency of a firm through the supply chain financing capability and trade credit. We also postulate that CDS leads to enhanced efficiency through institutional monitoring and improvements in management effectiveness. We then obtain suggestive evidence. Our findings have direct implications concerning the ongoing policy debate surrounding CDS. We contribute to operations management research by exploring how innovations in the financial market would, in turn, affect the operational performance of firms.

Credit Default Swaps and Lender Incentives in Bank Debt Renegotiations

AbstractUsing a regression-discontinuity design and within lender–borrower variation, we analyze how credit default swaps (CDSs) affect bank incentives and borrower outcomes in renegotiations after covenant violations. While existing studies document an investment decline after covenant violations, we find that covenant-violating firms maintain their investment subsequent to the introduction of CDS trading. Moreover, after CDS introduction, covenant-violating firms are less likely to default. Our results suggest that in the private debt markets, CDSs discipline borrowers, while the empty creditor problem due to CDS is mitigated because of lenders’ reputation concerns and lower coordination frictions.

Credit default swaps and corporate performance smoothing

This study examines whether the availability of traded credit default swaps (CDS) influences the referenced firms' incentive to smooth their performance. We show that with the introduction of CDS trading on their debt, CDS-referenced firms (CDS firms) lower both their earnings and cash flow volatility. Specifically, earnings volatility declines faster than cash flow volatility, which is consistent with income smoothing behavior. The effect of CDS trading on performance smoothing is qualitatively similar under different market and economic conditions. These results support the notion that CDS firms smooth their performance to avoid renegotiation with CDS-protected creditors. We also find that CDS firms smooth their cash flows via hedging with derivatives and smooth their earnings using discretionary accruals after the inception of CDS trading.

The information content of CDS implied volatility and associated trading strategies

Using the theoretical link between put options and credit default swaps (CDS) in a very general setting, we develop a robust measure of CDS implied volatility (CIV) that captures the information content of CDS markets. Specifically, we use the unit recovery claim to bridge CDS and deep out-of-the-money put options of the same firm and then back out CIV via the binomial tree. Our CIV measure strongly co-moves with the option implied volatility (OIV), with a correlation coefficient of 0.8. Based on the standardized difference between CIV and OIV, we construct CDS and option trading strategies. Without taking transaction costs into account, the long–short CDS trading strategy achieves an annualized return of 58.29% and a Sharpe ratio of 2.97, which cannot be explained by non-parametric skewness and volatility risk.

CDS trading and analyst optimism

This paper investigates whether and how the initiation of Credit Default Swaps (CDS) trading affects analyst forecast optimism. First, we document that the initiation of CDS trading curbs analyst forecasts optimism. Second, we find that the dampening effect of CDS on analyst optimism is stronger for firms with negative news and for firms with poorer financial performance or higher leverage, supporting a “correction effect” of CDS on non-strategic optimism. Moreover, we find that CDS also has a “disciplining effect” on strategic optimism that arises from incentives to cultivate relation with management or to please institutional investors. Overall, our evidence shows that the CDS market not only provides important information for analysts, but also alters analysts’ reporting incentives and enhances their objectivity. Additional analysis shows that this effect has disappeared after the Dodd-Frank Act.

CDS Trading Initiation, Information Asymmetry, and Dividend Payout

This study uses an information-asymmetry framework to examine the effect of initiation of credit default swaps (CDS) trading on firm dividend payout policy. We find evidence that CDS initiation is associated with increasing dividends, which is consistent with firms distributing excess free cash flow to mitigate exacerbated manager-equityholder agency conflicts resulting from reduced monitoring by banks following CDS initiation. Additional findings support this explanation by showing that the dividend increases are concentrated among borrowing firms with higher agency cost before CDS initiation, among firms whose lead arranger banks have a relatively less strong reputation in the loan-syndication market, and among firms whose loans are subject to less intense monitoring features—that is, less restrictive loan covenants—following CDS initiation. Additional analyses also suggest that inferences are robust to controlling for the potential effects of CDS initiation on capital structure. This paper was accepted by Brain Bushee, accounting. Funding: Financial support from the Goizueta Business School, the Kenan-Flagler Business School, and the Business School UNSW Sydney is gratefully acknowledged. Supplemental Material: The data and internet appendix are available at https://doi.org/10.1287/mnsc.2022.4337 .