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

HKIMR Working Paper No.29/2012

68 Pages Posted: 22 Dec 2012  

Marti G. Subrahmanyam

New York University - Stern School of Business

Dragon Yongjun Tang

The University of Hong Kong - School of Economics and Finance

Sarah Qian Wang

University of Warwick; University of Warwick - Warwick Business School

Multiple version iconThere are 3 versions of this paper

Date Written: December 21, 2012

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.

Keywords: Credit Default Swaps, Credit Risk, Bankruptcy, Empty Creditor

Suggested Citation

Subrahmanyam, Marti G. and Tang, Dragon Yongjun and Wang, Sarah Qian, Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk (December 21, 2012). HKIMR Working Paper No.29/2012. Available at SSRN: https://ssrn.com/abstract=2192351 or http://dx.doi.org/10.2139/ssrn.2192351

Marti G. Subrahmanyam

New York University - Stern School of Business ( email )

Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)

Dragon Yongjun Tang (Contact Author)

The University of Hong Kong - School of Economics and Finance ( email )

KKL 1005
Pokfulam Road
Pokfulam
Hong Kong
(852)22194321 (Phone)

Sarah Qian Wang

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

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