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Credit Default Swaps in General Equilibrium: Endogenous Default and Credit‐Spread Spillovers

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  • R. MATTHEW DARST
  • EHRAZ REFAYET

Abstract

This paper shows that credit default swaps (CDS) can affect the type of debt firms issue. Firms face a trade‐off between investment scale and the cost of capital measured by the credit spread. Small‐scale investment is safe, fully collateralized, but earns modest profits in all states. Large‐scale investment is risky, requires a positive credit spread, but yields high profits only in good states and default in bad states. CDS only affect risky credit spreads, which in turn affects the opportunity cost of issuing collateralized, safe debt. Covered (Naked) CDS lower (raise) credit spreads and raise (lower) the likelihood of issuing risky debt. Finally, we show that CDS generate credit spread and investment spillovers for non‐CDS‐referenced firms.

Suggested Citation

  • R. Matthew Darst & Ehraz Refayet, 2018. "Credit Default Swaps in General Equilibrium: Endogenous Default and Credit‐Spread Spillovers," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 50(8), pages 1901-1933, December.
    • Handle: RePEc:wly:jmoncb:v:50:y:2018:i:8:p:1901-1933
    DOI: 10.1111/jmcb.12507
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    References listed on IDEAS

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    Cited by:

    1. Feixue Gong & Gregory Phelan, 2023. "Collateral constraints, tranching, and price bases," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 75(2), pages 317-340, February.
    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. Caglio, Cecilia & Darst, R. Matthew & Parolin, Eric, 2019. "Half-full or half-empty? Financial institutions, CDS use, and corporate credit risk," Journal of Financial Intermediation, Elsevier, vol. 40(C).
    4. Matt Darst & Ehraz Refayet, 2019. "Mixed Signals: Investment Distortions with Adverse Selection," Finance and Economics Discussion Series 2019-044, Board of Governors of the Federal Reserve System (U.S.).

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