Essays on Credit Default Swaps and Corporate Debt Financing Decisions

Abstract

The chapters of this dissertation examine the influence credit default swaps (CDS) have a number of different corporate debt financing outcomes. Chapter Two studies the effects CDS have on firm financing in a general equilibrium production economy with heterogeneous firms. Covered CDS lower borrowing costs for all firms even when CDS contracts are traded on only one firm type. This leads to higher investment levels in the economy, but raises the likelihood of default when productivity shocks are bad. Naked CDS raise borrowing costs for all firms even when CDS contracts trade on a single firm type. This lowers investment levels in the economy, and lowers the likelihood of default. Lastly, we show that both Covered and Naked CDS induce borrowing cost spillovers to all firm types even when CDS do not exist for all firm types.

Chapter Three investigates the effects that CDS have on the term-structure of corporate bonds. I find that covered CDS tend to lengthen average debt maturity which is consistent with recent empirical work. Covered CDS lower borrowing costs, the benefits of which become consolidated at the time of issuance when the firm issues long term debt rather than a sequence of short term bonds, which exposes the firm to bond price updating. Additionally, naked CDS may shorten average debt maturity and create “maturity mis-match” in corporate debt markets. Naked CDS raise borrowing costs which also become consolidated at the time of issuance when firms issue long term debt rather than short term bonds, and incentivizes the firm to issue risky short term debt. Furthermore, naked CDS may destroy equilibrium whenever firms issue short term debt.

Chapter Four tests whether trading in CDS markets lead to borrowing cost spillovers across firms that are not named reference entities in CDS transactions. General equilibrium models of firm financing with CDS suggest that collateralized CDS contracts may reallocate capital away from bond markets and into derivative markets. We find evidence, conditional on firm rating, that the introduction of CDS affects the cost of issuing bonds for firms who are not single-named CDS reference entities. Borrowing costs for investment-grade firms increase, whereas borrowing costs for high-yield firms decrease when CDS are introduced for equivalently rated firms. We attribute the difference in borrowing costs across ratings classes due to differences in how CDS affect the liquidity of investment-grade versus high-yield corporate bonds. Various robustness checks are conducted for the endogeneity of both CDS introduction and bond issuance.