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Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk

Author

Listed:
  • Marti G. Subrahmanyam

    (New York University)

  • Dragon Yongjun Tang

    (University of Hong Kong and Hong Kong Institute for Monetary Research)

  • Sarah Qian Wang

    (Sarah Qian Wang)

Abstract

Credit default swaps (CDS) are derivative contracts that are widely used as tools for credit risk management. However, in recent years, concerns have been raised about whether CDS trading itself affects the credit risk of the reference entities. We use a unique, comprehensive sample covering CDS trading of 901 North American corporate issuers, between June 1997 and April 2009, to address this question. We find that the probability of both a credit rating downgrade and bankruptcy increase, with large economic magnitudes, after the inception of CDS trading. This finding is robust to controlling for the endogeneity of CDS trading. Beyond the CDS introduction effect, we show that firms with relatively larger amounts of CDS contracts outstanding, and those with relatively more "no restructuring" contracts than other types of CDS contracts covering restructuring, are more adversely affected by CDS trading. Moreover, the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure for the resolution of financial distress.

Suggested Citation

  • Marti G. Subrahmanyam & Dragon Yongjun Tang & Sarah Qian Wang, 2012. "Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk," Working Papers 292012, Hong Kong Institute for Monetary Research.
    • Handle: RePEc:hkm:wpaper:292012
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    References listed on IDEAS

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    Cited by:

    1. Jaewon Choi & Or Shachar, 2013. "Did liquidity providers become liquidity seekers?," Staff Reports 650, Federal Reserve Bank of New York.
    2. Juliana Salomao, 2015. "Sovereign Debt Renegotiation and Credit Default Swaps," 2015 Meeting Papers 826, Society for Economic Dynamics.
    3. Xu, Xin, 2013. "Forecasting Bankruptcy with Incomplete Information," MPRA Paper 55024, University Library of Munich, Germany, revised 31 Mar 2014.
    4. Agostino Capponi & Martin Larsson, 2014. "Will banning naked CDS impact bond prices?," Annals of Finance, Springer, vol. 10(3), pages 481-508, August.
    5. Bolton, Patrick & Oehmke, Martin, 2013. "Strategic conduct in credit derivative markets," International Journal of Industrial Organization, Elsevier, vol. 31(5), pages 652-658.

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