Investment Risk, CDS Insurance, and Firm Financing

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.

Keywords: CDS, Empty Creditors, Bankruptcy, Financing Efficiency, Regulation

JEL Classification: G33, D86, D61