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Investment risk, CDS insurance, and firm financing

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  • Campello, Murillo
  • Matta, Rafael

Abstract

We develop a model in which investment risk drives the demand for CDS insurance. The model shows the efficiency of CDS contracting over the state of the economy. It shows that CDS overinsurance (insurance in excess of renegotiation surpluses) is procyclical, allowing for greater financing when the probability of default is lower. Our theory predicts that the incidence of so-called “empty creditors” is largely constrained to firms that are safer, face lower bankruptcy costs, have more severe management-creditor agency problems, and whose assets are costlier to verify. Our analysis generates a number of empirical predictions and provides new insights into the regulation of CDS markets.

Suggested Citation

  • Campello, Murillo & Matta, Rafael, 2020. "Investment risk, CDS insurance, and firm financing," European Economic Review, Elsevier, vol. 125(C).
    • Handle: RePEc:eee:eecrev:v:125:y:2020:i:c:s0014292120300568
    DOI: 10.1016/j.euroecorev.2020.103424
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    References listed on IDEAS

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    Cited by:

    1. Li, Jay Y. & Tang, Dragon Yongjun, 2022. "Product market competition with CDS," Journal of Corporate Finance, Elsevier, vol. 73(C).
    2. 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).
    3. Kim, Gi H., 2016. "Credit derivatives as a commitment device: Evidence from the cost of corporate debt," Journal of Banking & Finance, Elsevier, vol. 73(C), pages 67-83.

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    More about this item

    Keywords

    CDS; Bankruptcy; Moral hazard; Financing efficiency; Regulation;
    All these keywords.

    JEL classification:

    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis

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