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Are credit default swaps associated with higher corporate defaults?

  • Stavros Peristiani
  • Vanessa Savino

Are companies with traded credit default swap (CDS) positions on their debt more likely to default? Using a proportional hazard model of bankruptcy and Merton’s contingent claims approach, we estimate the probability of default for U.S. nonfinancial firms. Our analysis does not generally find a persistent link between CDS and default over the entire period 2001-08, but does reveal a higher probability of default for firms with CDS over the last few years of that period. Further, we find that firms trading in the CDS market exhibited a higher Moody’s KMV expected default frequency during 2004-08. These findings are consistent with those of Henry Hu and Bernard Black, who argue that agency conflicts between hedged creditors and debtors would increase the likelihood of corporate default. In addition, our paper highlights other explanations for the higher defaults of CDS firms. Consistent with fire-sale spiral theories, we find a positive link between institutional ownership exposure and corporate distress, with CDS firms facing stronger selling pressures during the recent financial turmoil.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 494.

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Date of creation: 2011
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Handle: RePEc:fip:fednsr:494
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  1. Joshua D. Coval & Erik Stafford, 2005. "Asset Fire Sales (and Purchases) in Equity Markets," NBER Working Papers 11357, National Bureau of Economic Research, Inc.
  2. Hamid Mehran & Stavros Peristiani, 2010. "Financial Visibility and the Decision to Go Private," Review of Financial Studies, Society for Financial Studies, vol. 23(2), pages 519-547, February.
  3. Harald HAU & Sandy LAI, . "The Role of Equity Funds in the Financial Crisis Propagation," Swiss Finance Institute Research Paper Series 11-35, Swiss Finance Institute.
  4. Paul A. Gompers & Andrew Metrick, 2001. "Institutional Investors and Equity Prices," The Quarterly Journal of Economics, Oxford University Press, vol. 116(1), pages 229-259.
  5. John Y. Campbell & Jens Hilscher & Jan Szilagyi, 2005. "In Searach of Distress Risk," Harvard Institute of Economic Research Working Papers 2081, Harvard - Institute of Economic Research.
  6. Lucy F. Ackert & George Athanassakos, 2003. "A Simultaneous Equations Analysis of Analysts' Forecast Bias, Analyst Following, and Institutional Ownership," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30, pages 1017-1042.
  7. Markus K. Brunnermeier & Lasse Heje Pedersen, 2007. "Market liquidity and funding liquidity," LSE Research Online Documents on Economics 24478, London School of Economics and Political Science, LSE Library.
  8. Cella, Cristina & Ellul, Andrew & Giannetti, Mariassunta, 2010. "Investors' horizons and the Amplification of Market Shocks," CEPR Discussion Papers 8083, C.E.P.R. Discussion Papers.
  9. Gilson, Stuart C. & John, Kose & Lang, Larry H. P., 1990. "Troubled debt restructurings*1: An empirical study of private reorganization of firms in default," Journal of Financial Economics, Elsevier, vol. 27(2), pages 315-353, October.
  10. Sangkyun Park & Stavros Peristiani, 2001. "Are bank shareholders enemies of regulators or a potential source of market discipline?," Staff Reports 138, Federal Reserve Bank of New York.
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