Credit Derivatives as a Commitment Device: Evidence from the Cost of Corporate Debt

44 Pages Posted: 15 Apr 2013 Last revised: 26 Dec 2019

See all articles by Gi H. Kim

Gi H. Kim

Warwick Business School - University of Warwick

Date Written: July 8, 2016

Abstract

When a firm writes incomplete debt contracts, its limited ability to commit to not strategically default and renegotiate its debt requires the firm to pay higher yields to its creditors. Hedged by credit derivatives, creditors have stronger bargaining power in the case of debt renegotiation, which ex-ante demotivates the firm to default strategically. In this paper, I aim to investigate theoretically and empirically whether credit derivatives could help reduce the cost of debt contracting stemming from the possibility of strategic default. I find that firms with a priori high strategic default incentives experience a relatively large reduction in their corporate bond spreads after the introduction of credit default swaps (CDS) written on their debt. This result is robust to controlling for the endogeneity of CDS introduction. My finding is consistent with the presence of CDS reducing the strategic default-related cost of corporate debt, suggesting the beneficial role of credit derivatives as a commitment device for the borrower to repay the lender.

Keywords: Credit default swaps; Empty creditors; Cost of corporate debt; Corporate bond yields

JEL Classification: G10, G13, G30, G33

Suggested Citation

Kim, Gi Hyun, Credit Derivatives as a Commitment Device: Evidence from the Cost of Corporate Debt (July 8, 2016). Journal of Banking and Finance, Vol. 73, 67-83, December 2016, WBS Finance Group Research Paper No. 201, Available at SSRN: https://ssrn.com/abstract=2230394 or http://dx.doi.org/10.2139/ssrn.2230394

Gi Hyun Kim (Contact Author)

Warwick Business School - University of Warwick ( email )

Coventry CV4 7AL
United Kingdom
+44 (0)24 7652 3849 (Phone)

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