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Credit Default Swaps and Debt Overhang

Author

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  • Tak-Yuen Wong

    (Department of Quantitative Finance, National Tsing Hua University, Hsinchu 300044, Taiwan)

  • Jin Yu

    (Department of Banking and Finance, Monash Business School, Monash University, Melbourne, Victoria 3145, Australia)

Abstract

We analyze the impact of credit default swaps (CDSs) 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 pledgable 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.

Suggested Citation

  • Tak-Yuen Wong & Jin Yu, 2022. "Credit Default Swaps and Debt Overhang," Management Science, INFORMS, vol. 68(3), pages 2069-2097, March.
    • Handle: RePEc:inm:ormnsc:v:68:y:2022:i:3:p:2069-2097
    DOI: 10.1287/mnsc.2020.3953
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