The Impact of Credit Default Swaps on Corporations and Financial Markets.

Abstract

Credit Default Swap (CDS) is one of the most salient financial innovations and the utility of CDS markets to our economy is still subject to a heated debate. This dissertation examines the economic impact of CDS on corporations (first chapter) and financial markets (second chapter). In the first chapter, I provide the evidence of CDS playing new economic roles as a commitment device for the borrower (i.e. the firm) to repay their debt to lenders (i.e. creditors). When the firm writes incomplete debt contracts, its limited ability to commit not to default strategically in the future incurs the cost of contracting that will be ultimately paid by the firm. CDS can reduce this cost ex ante by strengthening creditors’ bargaining power in debt renegotiation. I identify, both theoretically and empirically, the benefit of CDS reducing the contracting cost arising from the possibility of the firm’s strategic default. I show that firms a priori most likely to face the limited commitment problem (i.e. firms with high strategic default incentives) experience a relatively larger reduction in their corporate bond spreads following the introduction of CDS.

In the second chapter, coauthored with Haitao Li and Weina Zhang, we provide a comprehensive empirical analysis on the implication of CDS-Bond basis arbitrage for the pricing of corporate bonds. Basis arbitrageurs introduce new risks such as funding liquidity and counter-party risk into the corporate bond market, which was dominated by passive investors before the existence of CDS. We show that a basis factor, constructed as the return differential between LOW and HIGH quintile basis portfolios, is a superior empirical proxy that captures the new risks. In the cross-section of investment grade bond returns, the basis factor carries an annual risk premium of about 3% in normal periods. However, speculative grade bonds are not affected by the basis factor as they are not widely used in the basis arbitrage.