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Financial decisions involving credit default swaps over the business cycle

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  • Gan, Liu
  • Yang, Zhaojun

Abstract

We propose a modeling approach to disentangle how idiosyncratic and aggregate shocks shape the impact of credit default swaps (CDSs) on CDS firms' financial decisions. Our relatively parsimonious model highlights a novel mechanism contributing to CDS procyclicality. We show that CDSs postpone debt renegotiation and risk-taking investment. CDS firms have higher leverage ratios than non-CDS firms. CDS firms' leverage and credit spreads are counter-cyclical. CDS firms' debt overhang is less significant than non-CDS firms. CDSs can increase or decrease CDS firms' value, depending on macroeconomic conditions, idiosyncratic risk, and borrowers' bargaining power. Empirical studies verify some model predictions.

Suggested Citation

  • Gan, Liu & Yang, Zhaojun, 2024. "Financial decisions involving credit default swaps over the business cycle," Journal of Economic Dynamics and Control, Elsevier, vol. 161(C).
    • Handle: RePEc:eee:dyncon:v:161:y:2024:i:c:s0165188924000228
    DOI: 10.1016/j.jedc.2024.104830
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    More about this item

    Keywords

    Credit default swaps; CDS hedging; Debt renegotiation; Risk-taking; Business cycles;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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