Credit default swaps and firm risk

• Published date: 01 November 2023
• Author: Hai Lin,Binh Hoang Nguyen,Junbo Wang,Cheng Zhang
• Date: 01 November 2023
• DOI: http://doi.org/10.1002/fut.22452

Received: 27 October 2021

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Accepted: 25 June 2023

DOI: 10.1002/fut.22452

RESEARCH ARTICLE

Credit default swaps and firm risk

Hai Lin

1

|Binh Hoang Nguyen

2

|Junbo Wang

3

|Cheng Zhang

4

1

School of Economics and Finance,

Victoria University of Wellington,

Wellington, New Zealand

2

The Business School, RMIT University,

Vietnam Campus, Ho Chi Minh City,

Vietnam

3

Department of Economics and Finance,

City University of Hong Kong, Kowloon,

Hong Kong

4

Reiman School of Finance, Daniels

College of Business, University of Denver,

Denver, Colorado, USA

Correspondence

Binh Hoang Nguyen, The Business

School, RMIT University, Vietnam

Campus, Ho Chi Minh City, Vietnam.

Email: binh.nguyen44@rmit.edu.vn

Abstract

This study investigates how initiating a credit default swap (CDS) affects firm

risk. Using the firm value volatility as a measure of firm risk, we document

that firm risk decreases following the commencement of CDS trading. Further

analysis indicates that the empty creditor channel, which arises when a debt

holder with CDS protection has no interest in preserving the company it

provides funds, is the primary way of influence. Our findings reveal a

significant impact of financial innovation on a firm's behavior. We also

document that market frictions affect the degree of such effect.

KEYWORDS

credit default swap, credit quality, empty creditor, financial constraint, firm value volatility

JEL CLASSIFICATION

G12, G14, G32

1|INTRODUCTION

A credit default swap (CDS) is an insurance contract under which buyers make periodic payments over the contract's

life to insure against credit events related to the underlying entities.

1

As an efficient tool for lenders or bond investors to

hedge the credit exposures associated with their investments in the firm while maintaining their control rights, the

CDS market has developed quickly over the last two decades.

2

The impact of this new but fast‐growing credit derivative

market has attracted considerable attention from financial researchers. For example, Saretto and Tookes (2013),

Subrahmanyam et al. (2014,2017), Martin and Roychowdhury (2015), and Danis and Gamba (2018), among others,

provide evidence on how CDSs affect firm behavior. Not only does understanding the effect of CDSs on firm behavior

help us address the critical question of whether financial innovation affects corporate finance, but it also can improve

portfolio decision making. While there exists extensive literature investigating the impact of CDS inception on various

firm behavior,

3

how these behaviors overall affect firm risk remains an underexplored question.

J Futures Markets. 2023;43:1668–1692.1668

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wileyonlinelibrary.com/journal/fut

This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial‐NoDerivs License, which permits use and distribution in any

medium, provided the original work is properly cited, the use is non‐commercial and no modifications or adaptations are made.

© 2023 The Authors. The Journal of Futures Markets published by Wiley Periodicals LLC.

1

Credit events include bankruptcy, failure to pay, obligation acceleration, obligation default, repudiation/moratorium, and restructuring

(ISDA, 2003).

2

In March 2019, the CDS market's notional amount exceeded 10 trillion US dollars (http://swapsinfo.org/swaps-notional-outstanding/).

3

Saretto and Tookes (2013) find that firms involved with CDS trading have higher leverage ratios and longer debt maturities. Subrahmanyam et al.

(2014) show that a firm is more likely to declare bankruptcy after engaging in CDS trading. Martin and Roychowdhury (2015) document a decrease

in borrowing firms' reporting conservatism (i.e., their asymmetry in recognition of losses vs. gains) after the initiation of CDS trading.

Subrahmanyam et al. (2017) show that firms increase their cash holdings after CDS trading on their debt has commenced.

CDS inception affects firm risk from both demand‐and supply‐side. The demand‐side arguments propose the empty

creditor and monitoring channels, while the supply‐side arguments suggest the financing channel.

4

The empty creditor

channel posits that a debt holder with CDS protection has no interest in preserving the company it provides funds and

thus becomes exacting in debt renegotiation. To avoid this, borrowing firms tend to make more prudent decisions on

investment and other corporate activities. Conversely, the monitoring channel implies that CDS trading serves as a

hedge against default risk, consequently reducing creditors' incentive to monitor. This reduction in monitoring

incentives allows firms to engage in riskier projects that could potentially benefit equity investors. In addition, the

financing channel suggests that CDS inception reduces friction in credit supply, thereby increasing financial leverage

and affecting firm risk.

The extant literature, drawing upon these channels, has proposed several different mechanisms through which CDS

inception could influence the risks undertaken by firms. While the empty creditor and financing channels suggest a

negative association between CDS inception and risk, the monitoring channel predicts an increase in firm risk

following CDS inception. These effects generate varying predictions on firm risk, and it is essentially an open empirical

question to study the aggregate effects of these channels.

Our study examines the effect of CDS inception on firm risk. Firm risk provides an overall assessment of the firm's

risk‐taking behaviors because it reveals the net effect of all corporate risk‐taking activities (Low, 2009). Low (2009)

argues that using cash flow volatility to measure firm risk is problematic, and Choi and Richardson (2016) demonstrate

that a firm's value volatility is fundamentally different from its equity volatility.

5

Furthermore, firm value volatility

plays a vital role in the valuation of capital structure and in the risk‐return trade‐offs independent of firm leverage

(Choi & Richardson, 2016). A firm's level of risk also bears crucial implications for its hiring and investment behavior

and other economic activities. For instance, Bloom (2009) shows that (a) firms prefer to delay both hiring and

investment during periods of higher uncertainty and (b) increased firm risk due to uncertainty shocks leads to an

overshoot in output, employment, and productivity. We follow prior studies by using firm value volatility—rather than

volatility in the firm's equity or cash flow—to measure firm risk.

6

We use the structural model of Merton (1974) to estimate firm value volatility. Since the measure that Merton uses

incorporates information on both equity and debt, it differs from equity volatility in being better able to capture a firm's

overall level of risk. We follow Vassalou and Xing (2004) and Bharath and Shumway (2008) in employing an iterative

procedure to estimate firm value volatility. To address the issue of endogeneity, we use both propensity score (PS)

matching and an instrumental variable (IV) approach.

We document several interesting findings. First, we find that firm value volatility decreases after the introduction of

CDS trading. When our regressions feature CDS firms matched up against their closest one (i.e., the most similar) non‐

CDS counterparts, firm value volatility declines by about 5.20% following CDS inception; similar results are obtained

when we use other matched samples. This negative effect amounts to 12.50% when assessed via an IV approach. These

results suggest that firms become more conservative about their risk‐taking behavior once CDS trading begins.

Second, we examine the channels driving the negative effects. To test the existence of the empty creditor channel,

we employ institutional ownership as a proxy for shareholder bargaining power. We document that the negative effect

of CDS inception on firm value volatility is more pronounced for firms with high shareholder bargaining power. This

finding corroborates the empty creditor channel. To test the financing channel, we examine whether the effect of CDS

inception on firm value volatility is a function of financial constraints. We use the index developed by Whited and Wu

(2006) (hereafter WW index) and credit quality as proxies for financial constraints. We show that the decreased firm

value volatility induced by CDS trading is more significant for less financially constrained firms. However, we do not

find evidence to suggest that the financing channel drives the negative effect of CDS inception on firm risk.

Using the absolute value of a firm's CDS–bond basis to measure the price discrepancy between the corporate bond

and the CDS market, we establish that the effect of CDS trading is weaker on firms for which that price discrepancy is

greater. Since a more pronounced price discrepancy is indicative of more arbitrage limitations and also of less

integration between the CDS and the corporate bond market, this finding provides empirical evidence that market

frictions influence the extent to which financial innovation affects firm behaviors, which supports the notion that

policymakers should be aware of the effects of such frictions.

4

Section 2provides a detailed discussion of theoretical backgrounds and hypothesis development.

5

In addition, Doshi et al. (2019) identify significant differences in the behavior of unlevered asset returns versus levered stock returns.

6

In Appendix 2, we show that the relationship between firm value volatility and equity volatility is uncertain.

LIN ET AL.

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