IDEAS home Printed from https://ideas.repec.org/a/eee/eecrev/v125y2020ics0014292120300568.html
   My bibliography  Save this article

Investment risk, CDS insurance, and firm financing

Author

Listed:
  • Campello, Murillo
  • Matta, Rafael

Abstract

We develop a model in which investment risk drives the demand for CDS insurance. The model shows the efficiency of CDS contracting over the state of the economy. It shows that CDS overinsurance (insurance in excess of renegotiation surpluses) is procyclical, allowing for greater financing when the probability of default is lower. Our theory predicts that the incidence of so-called “empty creditors” is largely constrained to firms that are safer, face lower bankruptcy costs, have more severe management-creditor agency problems, and whose assets are costlier to verify. Our analysis generates a number of empirical predictions and provides new insights into the regulation of CDS markets.

Suggested Citation

  • Campello, Murillo & Matta, Rafael, 2020. "Investment risk, CDS insurance, and firm financing," European Economic Review, Elsevier, vol. 125(C).
    • Handle: RePEc:eee:eecrev:v:125:y:2020:i:c:s0014292120300568
    DOI: 10.1016/j.euroecorev.2020.103424
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0014292120300568
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.euroecorev.2020.103424?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Oliver Hart & John Moore, 1998. "Default and Renegotiation: A Dynamic Model of Debt," The Quarterly Journal of Economics, Oxford University Press, vol. 113(1), pages 1-41.
    2. Campello, Murillo & Matta, Rafael, 2012. "Credit default swaps and risk-shifting," Economics Letters, Elsevier, vol. 117(3), pages 639-641.
    3. Murillo Campello & Tomislav Ladika & Rafael Matta, 2019. "Renegotiation Frictions and Financial Distress Resolution: Evidence from CDS Spreads," Review of Finance, European Finance Association, vol. 23(3), pages 513-556.
    4. Parlour, Christine A. & Winton, Andrew, 2013. "Laying off credit risk: Loan sales versus credit default swaps," Journal of Financial Economics, Elsevier, vol. 107(1), pages 25-45.
    5. Alan D. Morrison, 2005. "Credit Derivatives, Disintermediation, and Investment Decisions," The Journal of Business, University of Chicago Press, vol. 78(2), pages 621-648, March.
    6. Subrahmanyam, Marti G. & Tang, Dragon Yongjun & Wang, Sarah Qian, 2017. "Credit default swaps, exacting creditors and corporate liquidity management," Journal of Financial Economics, Elsevier, vol. 124(2), pages 395-414.
    7. Mascia Bedendo & Lara Cathcart & Lina El‐Jahel, 2016. "Distressed Debt Restructuring in the Presence of Credit Default Swaps," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 48(1), pages 165-201, February.
    8. Larry E. Jones & Rodolfo E. Manuelli, 2001. "Endogenous Policy Choice: The Case of Pollution and Growth," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(2), pages 369-405, July.
    9. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
    10. Ashcraft, Adam B. & Santos, João A.C., 2009. "Has the CDS market lowered the cost of corporate debt?," Journal of Monetary Economics, Elsevier, vol. 56(4), pages 514-523, May.
    11. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
    12. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
    13. Stefan Krasa & Anne P. Villamil, 2000. "Optimal Contracts when Enforcement Is a Decision Variable," Econometrica, Econometric Society, vol. 68(1), pages 119-134, January.
    14. Patrick Bolton & Martin Oehmke, 2011. "Credit Default Swaps and the Empty Creditor Problem," The Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2617-2655.
    15. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
    16. M. Dewatripont & E. Maskin, 1995. "Credit and Efficiency in Centralized and Decentralized Economies," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 62(4), pages 541-555.
    17. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 25-54, August.
    18. Henry T. C. Hu & Bernard Black, 2008. "Debt, Equity and Hybrid Decoupling: Governance and Systemic Risk Implications," European Financial Management, European Financial Management Association, vol. 14(4), pages 663-709, September.
    19. Christine A. Parlour & Guillaume Plantin, 2008. "Loan Sales and Relationship Banking," Journal of Finance, American Finance Association, vol. 63(3), pages 1291-1314, June.
    20. Roberts, Michael R. & Sufi, Amir, 2009. "Renegotiation of financial contracts: Evidence from private credit agreements," Journal of Financial Economics, Elsevier, vol. 93(2), pages 159-184, August.
    21. Christine Parlour & Guillaume Plantin, 2008. "Loan Sales and Relationship Banking," Post-Print hal-03415832, HAL.
    22. Hu, Henry T.C. & Black, Bernard, 2007. "Hedge funds, insiders, and the decoupling of economic and voting ownership: Empty voting and hidden (morphable) ownership," Journal of Corporate Finance, Elsevier, vol. 13(2-3), pages 343-367, June.
    23. Marti G. Subrahmanyam & Dragon Yongjun Tang & Sarah Qian Wang, 2014. "Does the Tail Wag the Dog?: The Effect of Credit Default Swaps on Credit Risk," Review of Financial Studies, Society for Financial Studies, vol. 27(10), pages 2927-2960.
    24. Alessio Saretto & Heather E. Tookes, 2013. "Corporate Leverage, Debt Maturity, and Credit Supply: The Role of Credit Default Swaps," Review of Financial Studies, Society for Financial Studies, vol. 26(5), pages 1190-1247.
    25. Hirtle, Beverly, 2009. "Credit derivatives and bank credit supply," Journal of Financial Intermediation, Elsevier, vol. 18(2), pages 125-150, April.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kim, Gi H., 2016. "Credit derivatives as a commitment device: Evidence from the cost of corporate debt," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 67-83.
    2. Li, Jay Y. & Tang, Dragon Yongjun, 2022. "Product market competition with CDS," Journal of Corporate Finance, Elsevier, vol. 73(C).

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Augustin, Patrick & Subrahmanyam, Marti G. & Tang, Dragon Yongjun & Wang, Sarah Qian, 2014. "Credit Default Swaps: A Survey," Foundations and Trends(R) in Finance, now publishers, vol. 9(1-2), pages 1-196, December.
    2. Hwang Hee Lee & Frederick Dongchuhl Oh, 2022. "The role of credit default swaps in determining corporate payout policy," Financial Management, Financial Management Association International, vol. 51(2), pages 635-661, June.
    3. Söhnke M Bartram & Jennifer Conrad & Jongsub Lee & Marti G Subrahmanyam, 2022. "Credit Default Swaps around the World," Review of Financial Studies, Society for Financial Studies, vol. 35(5), pages 2464-2524.
    4. Arping, Stefan, 2014. "Credit protection and lending relationships," Journal of Financial Stability, Elsevier, vol. 10(C), pages 7-19.
    5. Caglio, Cecilia & Darst, R. Matthew & Parolin, Eric, 2019. "Half-full or half-empty? Financial institutions, CDS use, and corporate credit risk," Journal of Financial Intermediation, Elsevier, vol. 40(C).
    6. Oehmke, Martin & Zawadowski, Adam, 2015. "Synthetic or real? The equilibrium effects of credit default swaps on bond markets," LSE Research Online Documents on Economics 84511, London School of Economics and Political Science, LSE Library.
    7. Colonnello, Stefano, 2017. "Internal governance and creditor governance: Evidence from credit default swaps," IWH Discussion Papers 6/2017, Halle Institute for Economic Research (IWH).
    8. Oehmke, Martin & Zawadowski, Adam, 2016. "The anatomy of the CDS market," LSE Research Online Documents on Economics 118964, London School of Economics and Political Science, LSE Library.
    9. Kim, Gi H., 2016. "Credit derivatives as a commitment device: Evidence from the cost of corporate debt," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 67-83.
    10. Clark, Brian & Donato, James & Francis, Bill B & Shohfi, Thomas D, 2023. "Bank loan renegotiation and credit default swaps," Journal of Banking & Finance, Elsevier, vol. 151(C).
    11. Amin, Abu & Jain, Pawan & Upadhyay, Arun, 2022. "CDS, CEO compensation, and firm value," Finance Research Letters, Elsevier, vol. 46(PB).
    12. Arnold, M., 2017. "The impact of central clearing on banks’ lending discipline," Journal of Financial Markets, Elsevier, vol. 36(C), pages 91-114.
    13. Martin, Xiumin & Roychowdhury, Sugata, 2015. "Do financial market developments influence accounting practices? Credit default swaps and borrowers׳ reporting conservatism," Journal of Accounting and Economics, Elsevier, vol. 59(1), pages 80-104.
    14. Tak-Yuen Wong & Jin Yu, 2022. "Credit Default Swaps and Debt Overhang," Management Science, INFORMS, vol. 68(3), pages 2069-2097, March.
    15. Shan, Chenyu & Tang, Dragon Yongjun & Winton, Andrew, 2019. "Do banks still monitor when there is a market for credit protection?," Journal of Accounting and Economics, Elsevier, vol. 68(2).
    16. A. Hong, Hyun & Lobo, Gerald J. & Ryou, Ji Woo, 2019. "Financial market development and firm investment in tax avoidance: Evidence from credit default swap market," Journal of Banking & Finance, Elsevier, vol. 107(C), pages 1-1.
    17. Jung Koo Kang & Christopher D. Williams & Regina Wittenberg-Moerman, 2021. "CDS trading and nonrelationship lending dynamics," Review of Accounting Studies, Springer, vol. 26(1), pages 258-292, March.
    18. Daniel Streitz, 2016. "The Impact of Credit Default Swap Trading on Loan Syndication," Review of Finance, European Finance Association, vol. 20(1), pages 265-286.
    19. Hasan, Iftekhar & Wu, Deming, 2016. "Credit default swaps and bank loan sales: evidence from bank syndicated lending," Bank of Finland Research Discussion Papers 9/2016, Bank of Finland.
    20. Clark, Brian & Donato, James & Francis, Bill B., 2023. "Credit default swaps and debt specialization," Journal of Financial Intermediation, Elsevier, vol. 54(C).

    More about this item

    Keywords

    CDS; Bankruptcy; Moral hazard; Financing efficiency; Regulation;
    All these keywords.

    JEL classification:

    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:eecrev:v:125:y:2020:i:c:s0014292120300568. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/eer .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.