Credit Default Swaps Trading Research Articles

The Effect of Credit Default Swaps on Risk Shifting

We study the effect of credit default swaps (CDS) on a firm's risk shifting. Because CDS provides insurance against default, bondholders become indifferent whether a firm defaults and likely reduce monitoring efforts. Moreover, CDS strengthens bondholders' bargaining power, potentially leading to higher default rates. Therefore, managers of financially distressed firms have more incentives to, and find it easier to take on excessive risk. Controlling for the possibility of reverse causality that CDS trading may arise in anticipation of risk shifting, and selection bias, we find empirical evidence that CDS trading causes financially distressed firms to engage in more risk shifting.

Credit default swaps and the market for sovereign debt

In this paper, we analyze the determinants and effects of credit default swap (CDS) trading initiation in the sovereign bond market. CDS trading initiation is associated with a 30–150 basis point reduction in sovereign bond yields, with greater yield reductions accruing to higher default risk economies. For countries with high default risk, rated B or lower by Standard and Poor’s, CDS initiation is also associated with significant price efficiency benefits in the underlying market. CDS trading initiation is more likely following increases in local equity index volatility, index spreads for regional and global CDS markets, or depreciation of the local currency relative to the US dollar, and decreases in a country’s ability to service foreign debt. Our results are robust to selection bias controls based on these factors.

Do financial market developments influence accounting practices? Credit default swaps and borrowers׳ reporting conservatism

This paper investigates whether the initiation of trading in credit default swaps (CDSs) on a borrowing firm׳s outstanding debt is associated with a decline in that firm׳s reporting conservatism. CDS investments can modify lenders׳ payoffs on their loan portfolios by providing insurance on negative credit outcomes. The onset of CDS trading reduces lenders׳ incentives to continuously monitor borrowers and also their demand that borrowers report conservatively. Additionally, borrowers expect CDS-insured lenders to be more intransigent in renegotiations triggered by defaults and covenant violations. Since conservatism can trigger earlier covenant violations, borrowers have heightened incentives to report less conservatively in the post-CDS period. Using a differences-in-differences research design, we observe a decline in borrowing firms׳ reporting conservatism after CDS trade initiation. This effect is more pronounced when reputation costs lenders face from reducing monitoring are lower, when debt contracts outstanding at the time of CDS trade initiation have more financial covenants, and when lenders who monitor borrowers more regularly in the pre-CDS period enter into CDS contracts to hedge their credit exposures.

Capital Structure Arbitrage Revisited

We study risk and return properties of capital structure arbitrage strategies aiming to profit from temporal mispricing between equity and credit default swaps (CDSs) of companies. We find that capital structure arbitrage provides an attractive annualized return of 24.35% on invested capital. The arbitrage returns are higher for lower rated companies and surprisingly they are also higher for more liquid companies with larger CDS trading volumes. We find that the number of open arbitrage trades can at times cluster and in our sample the concentration of trades occurs when they are most profitable, which highlights the issue of capital allocation. Constructing weekly return indices of capital structure arbitrage, we find that no more than 15% of the returns is explained by common risk factors.

Do Financial Market Developments Influence Accounting Practices? Credit Default Swaps and Borrowers’ Reporting Conservatism

This paper investigates whether the initiation of trading in credit default swaps (CDSs) on a borrowing firm’s outstanding debt is associated with a decline in that firm’s reporting conservatism. CDS investments can modify lenders’ payoffs on their loan portfolios by providing insurance on negative credit outcomes. The onset of CDS trading reduces lenders’ incentives to continuously monitor borrowers and also their demand that borrowers report conservatively. Additionally, borrowers expect CDS-insured lenders to be more intransigent in renegotiations triggered by defaults and covenant violations. Since conservatism can trigger earlier covenant violations, borrowers have heightened incentives to report less conservatively in the post-CDS period. Using a differences-in-differences research design, we observe a decline in borrowing firms’ reporting conservatism after CDS trade initiation. This effect is more pronounced when reputation costs lenders face from reducing monitoring are lower, when debt contracts outstanding at the time of CDS trade initiation have more financial covenants, and when lenders who monitor borrowers more regularly in the pre-CDS period enter into CDS contracts to hedge their credit exposures.

New Rules for Credit Default Swap Trading: Can We Now Follow the Risk?

Credit default swaps, a useful but complex financial innovation of the 1990s, were traded over the counter before the financial crisis. Because of this infrastructure, a very opaque market emerged, and from it, the severe risk imbalances that helped fuel the crisis. Reforms are now being worked out and put in place which will move the majority of credit default swaps transactions to more transparent exchanges. Market participants will be able to see pre-trade and post-trade pricing, and regulators will have access to information that will allow them to monitor risk concentrations as they develop and take actions before they become of systemic concern.

Does the Tail Wag the Dog?: The Effect of Credit Default Swaps on Credit Risk

We use credit default swaps (CDS) trading data to demonstrate that the credit risk of reference firms, reflected in rating downgrades and bankruptcies, increases significantly upon the inception of CDS trading, a finding that is robust after controlling for the endogeneity of CDS trading. Additionally, distressed firms are more likely to file for bankruptcy if they are linked to CDS trading. Furthermore, firms with more “no restructuring” contracts than other types of CDS contracts (i.e., contracts that include restructuring) are more adversely affected by CDS trading, and the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure in the resolution of financial distress.

Credit Default Swaps and Corporate Cash Holdings

Firms obtain improved access to credit supply after their debt is referenced by credit default swaps (CDS). However, CDS-referenced firms also face tougher creditors and greater refinancing risk. In this context, we examine how firms manage their liquidity in response to the introduction of CDS trading on their debt. We find that firms hold significantly more cash after the inception of CDS trading. This finding is robust to the endogeneity of CDS trading, using instrumental variables and propensity score matching. The increase in cash holding by CDS firms is more pronounced for firms with lines of credit, suggesting that banks with CDS protection impose greater discipline on firms, causing them to take a more conservative risk management approach.

Empty creditors and sovereign debt: what now?

... The place of credit default swaps (CDS) in sovereign finance has attracted high controversy in recent years. CDS—instruments that allow lenders to trade the economic risk of a loan or bond—have gained as much in fame as infamy through their short history. CDS on sovereign debt comprise a relatively small share of the overall CDS market1 but their workings have attracted enormous attention from domestic policy-makers. Not only are these instruments perceived as threats to financial stability but, insofar as CDS trade on domestic sovereign debt and impact treasury financing, their operations can prove risky for macroeconomic health. Fundamentally, commentators argue, CDS are uniquely primed to wreak havoc on sovereign and other credit markets. According to this view, lenders that purchase credit protection on debt lose all incentive to exercise good judgement and discipline with respect to their debtor. Rather, they possess an entirely different motivation. Namely, with their downside risk covered, lenders benefit as debtors veer ever closer to distress—and eventually default. With CDS in play, behaving recklessly—far from jeopardizing the creditor’s balance sheet—offers a very real pay-off: a quick and cheap exit from their investment and repayment on the CDS.2 Unsurprisingly then, the spread of sovereign crisis across the Eurozone in 2009–2011 has prompted regulators to critically examine—and sometimes swiftly curtail—CDS trading on their domestic sovereign debt.

Credit Default Swaps and Bank Risk Taking

Credit derivatives in the form of credit default swaps (CDS) are recognized by Basel II and Basel III as a tool for managing bank regulatory capital requirements. We find that banks become more aggressive in risk taking after they begin using credit derivatives. This increase in bank risk is linked to banks’ CDS trading. Loans issued to CDS-referenced borrowers are larger and have higher yield spreads if the lead banks in the syndicate are active in CDS trading. During the 2007-2009 credit crisis, banks with large positions in credit derivatives at the onset of the crisis raised more capital, reduced lending more, and experienced larger stock price drops than CDS-inactive banks. Although they take more risks, CDS-active banks have better operating and financial performance during normal times.

Regulation, Credit Risk Transfer with CDS, and Bank Lending

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank . CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price . Regulation is found to induce the risk-neutral bank to behav e in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases . CDS trading is found to interact with the former ef fect when regulation accepts CDS as an instrument to mitigate credit risk . Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased . Howev er, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased . This promotes the intention of the Basel II (and III) r egulations to “strengthen the soundness and stability of banks” . * Paper presented at the 2012 conferences of the European Financial Management Association (EFMA) in Barcelona and the Verein fur Socialpolitik in Gottingen, at the 2011 conference of the German Economic Association of Business Administration (GEABA) in Zurich, at the Financial Risks International Forum 2012 in Paris, at the 2011 workshop of the Research Task Force of the Basel Committee on Banking Supervision in Istanbul, and at the Bundesbank Research Seminar in Frankfurt . We w ould like to thank conference, workshop and seminar participants and in particular Ulrich Krueger, Peter Raupach, Thomas Gehrig, Bent Vale and Nikolaos Papanikolaou for valuable comments and suggestions . The views expr essed in this paper represent the authors’ personal opinions and do not neces

Did CDS trading improve the market for corporate bonds?

Financial innovation through the creation of new markets and securities impacts related markets as well, changing their efficiency, quality (pricing error), and liquidity. The credit default swap (CDS) market was undoubtedly one of the salient new markets of the past decade. In this paper we examine whether the advent of CDS trading was beneficial to the underlying secondary market for corporate bonds. We employ econometric specifications that account for information across CDS, bond, equity, and volatility markets. We also develop a novel methodology to utilize all observations in our data set even when continuous daily trading is not evidenced, because bonds trade much less frequently than equities. Using an extensive sample of CDS and bond trades over 2002–2008, we find that the advent of CDS was largely detrimental. Bond markets became less efficient, evidenced no reduction in pricing errors, and experienced no improvement in liquidity. These findings are robust to various slices of the data set and specifications of our tests.

Insider Trading in the Derivatives Market (and What it Means for Everyone Else)

The prohibition against insider trading is becoming increasingly anachronistic in markets where derivatives like credit default swaps (CDS) operate. Lenders use these instruments to trade the credit risk of the loans they extend. By design, CDS appear to subvert insider trading laws, insofar as lenders rely on what looks like insider information to transfer or externalize the risk of a loan to another institution. At the same time, the harm caused by using insider information in CDS markets can depart radically from the harms envisioned under existing case law. In the traditional account of insider trading, shareholders systematically lose against informed insiders. However, with CDS trading, shareholders of the debtor company can emerge as winners where this company enjoys access to cheaper credit and lower funding costs. A thorough re-thinking of traditional theory is thus required, as well as a more robust, theoretical account of the efficiency and welfare implications of insider trading in a world animated by complex derivatives markets. This Article shows that trading on insider information in CDS can improve at least the informational, if not also the allocative efficiency of financial markets in ways traditional accounts have scarcely anticipated. However, in doing so, CDS markets reveal that this informational gain can render markets too efficient where they impound new information selectively and with such force that market stability itself can suffer. Collectively, these observations suggest a need to revisit the insider trading prohibition itself – and to explore whether consistency can (and should) be brought to supervisory approaches in U.S. equity and derivatives markets.

Did CDS Trading Improve the Market for Corporate Bonds?

Financial innovation through the creation of new markets and securities impacts related markets as well, changing their efficiency, quality (pricing error) and liquidity. The credit default swap (CDS) market was undoubtedly one of the salient new markets of the past decade. In this paper we examine whether the advent of CDS trading was beneficial to the underlying secondary market for corporate bonds. We employ econometric specifications that account for information across CDS, bond, equity, and volatility markets. We also develop a novel methodology to utilize all observations in our data set even when continuous daily trading is not evidenced, because bonds trade much less frequently than equities. Using an extensive sample of CDS and bond trades over 2002-2008, we find that the advent of CDS was largely detrimental – bond markets became less efficient, evidenced no reduction in pricing errors, and experienced no improvement in liquidity. These findings are robust to various slices of the data set and specifications of our tests.

Corporate Governance and Debt Monitoring: The Role of Credit Default Swaps

I study the relation between internal governance and creditor governance. A deterioration in creditor governance may increase the agency costs of debt and managerial opportunism at the expense of shareholders. I exploit the introduction of credit default swaps (CDS) as a negative shock to creditor governance. I provide evidence consistent with shareholders pushing for a substitution effect between internal governance and creditor governance. Following CDS introduction, CDS firms reduce managerial risk-taking incentives relative to other firms. At the same time, after the start of CDS trading, CDS firms increase managerial wealth-performance sensitivity, board independence, and CEO turnover performance-sensitivity relative to other firms.

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 derives from customers referenced by CDS. 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 increase equity issuance and reduce investment, which is consistent with the view that CDS trading on customers improves the information environment for suppliers and provides information about customer default risk. Therefore, while many firms are not directly linked to CDS trading, CDS trading on their customers has spillover effects on these firms’ financial policies.

Are Credit Ratings Still Relevant?

We document that firms' stock prices react significantly less to credit rating downgrade announcements when credit default swaps (CDS) trade on their debts. The impact of CDS trading is more pronounced for firms with high-information and financing-related frictions. Prior to a rating downgrade, the ability to trade credit risk via CDS generates information flows from the CDS to equity markets, thereby decreasing the informativeness of credit rating downgrades. Ex post, the ability of lenders to hedge in the CDS market mitigates the loss in access to and cost of financing for downgraded firms. While the CDS market is not a perfect substitute for credit ratings, our results suggest that equity investors rely less on credit ratings in the presence of CDS trading.

A critical evaluation of the European credit default swap reform: Its challenges and adverse effects as a result of insufficient assumptions

An understanding of Over-The-Counter (OTC) derivatives – particularly Credit Default Swaps (CDSs) – is essential, because these derivatives are often accused of being toxic and a significant contributor to the financial turmoil of 2008, and therefore also indirectly causing the sickly world economic growth experienced since. This is the position embraced by high-level politicians at G20, in the EU and in the United States; therefore, an overhaul of the OTC derivatives – including the CDS market – appears inevitable. Nonetheless, this article questions this perception of CDSs as an exclusive detrimental product and argues that, although problems of concentration and interconnectedness in the opaque CDS market arguably amplified the crisis, CDSs merely reflected the crash of the US mortgage market. If this is not recognised by politicians and regulators, the likelihood of incomplete reforms causing unintended consequences seems inescapable. This scenario already seems to be playing out in Europe and also potentially in the United States, although an analysis of the US reform is beyond the scope of this article. This conclusion is reached by evaluating three proposals by the European Commission: the European Market Infrastructure Regulation, the Market in Financial Instruments Directive and the Capital Requirement Directive. In short, they intend to mandate or heavily incentivise the trading of CDSs through Central Counterparties (CCPs) and exchanges; enhance OTC-traded CDSs’ capital requirements; and require trades to be reported to designated trade repositories. Although these proposals are well intentioned, the unintended consequences could be considerable, particularly with regard to the extent to which credit risk hedging is possible through CDSs owing to potential prohibitive OTC capital, CCP and exchange-trading requirements. Rather, it is suggested that the reform could be detrimental to its inherent purpose, financial stability, as a concentration of credit risk can accumulate in CDS CCPs. Juxtapose market participants’ ability to hedge credit risk in the regular OTC market is diminished, thus positioning CDSs in a diminishing vacuum between the OTC and exchange traded market. In a worst case scenario, this would undermine the liquidity of the CDS market and make credit risk hedging significantly more difficult and expensive for end-users and ultimately society, at the same time as crucial information on entities creditworthiness deteriorates.

Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk

Concerns have been raised, especially since the global financial crisis, about whether trading in credit default swaps (CDS) increases the credit risk of the reference entities. We use a unique, comprehensive sample covering 901 CDS introductions on North American corporate issuers between June 1997 and April 2009 to address this question. We present evidence that the probability of credit rating downgrade and the probability of bankruptcy both increase after the inception of CDS trading. The effect is robust to controlling for the endogeneity of CDS introduction, i.e., the possibility that firms with upcoming deterioration in creditworthiness are more likely to be selected for CDS trading. We show that the CDS-protected lenders' reluctance to restructure is the most likely cause of the increase in credit risk. We present evidence that firms with relatively larger amounts of CDS contracts outstanding, and those with more No Restructuring contracts, are more likely to be adversely affected by CDS trading. We also document that CDS trading increases the level of participation of bank lenders to the firm. Our findings are broadly consistent with the predictions of the empty creditor model of Bolton and Oehmke (2011).

Savior or Sinner? Credit Default Swaps and the Market for Sovereign Debt

This paper analyzes the determinants and effect of credit default swap (CDS) trading initiation on sovereign bonds in 54 countries, focusing on market completeness, price efficiency and borrowing costs. We find that CDS initiation enhances market completeness in the majority of countries in our sample. Our results suggest that for high default risk and low financial openness countries, CDS initiation provides significant price efficiency benefits in the underlying market. In addition, we find that CDS initiation reduces risk premiums to investment-grade sovereigns while increasing borrowing costs for sub-investment-grade economies. CDS trading initiation is more likely following increases in local stock index volatility and the volatility risk premium and decreases in foreign currency reserves and the local currency exchange rate with the USD. Our results are robust to CDS initiation endogeneity controls constructed with these factors.