The Externalities of Credit Default Swaps on Industry Peers

Description

Credit default swaps (CDS) are among the most influential and controversial financial innovations in the recent decades. As an insurance-type of contract, they facilitate credit risk transfer, thus enhancing the opportunities for both risk-sharing and risk-taking. However, among industrial firms, only a handful of large corporations are referenced by CDS. Is the influence of CDS limited to those CDS-referenced firms only? In the proposed project, we study how CDS written on peer firms affect other non CDS-referenced firms in the same industry.Competing with each other in the product market, peer firms play a prominent role in shaping corporate financial decisions. Because CDS can affect or reflect underlying firms’ actions and characteristics, the trading of CDS on peer firms should have important impact on a firm’s financial policies. First, as a new facility for price discovery, CDS can convey new information about the risk outlook of the peer firms and the industry, which can be useful to guide the firm’s own financial policy. Second, as a new approach to hedging credit risk, CDS can facilitate credit supply to the peer firms, and may therefore affect the firm’s own access to credit.The proposed project investigates the empirical effect of peer CDS on firm leverage and examines the mechanisms that may lead to this effect. Understanding this effect will broaden our view on the interactions between product market competition, financial innovation, and corporate financial policies. It will also contribute to a growing strand of literature that analyzing individual firms’ capital structure decisions no longer in isolation but with connection to its business environment such as product market stake holders and competitors.