Credit Derivatives and Firm Investment

Abstract

We examine the effect of credit default swap (CDS) trading on firm investment, finding a post-CDS introduction decrease in debt issuance and acquisitions, which remains robust to propensity score matching, instrumenting CDS introduction, and controlling for past investment and financing activities. Further analysis reveals a CDS introduction-year increase in debt financing and acquisitions, for which we could not eliminate reverse causality as a potential explanation. Overall, the ex post increase in bankruptcy risk and debt overhang likely plays a dominant role in the investment effect of CDS, while the expansion in credit supply due to a reduction of strategic default or regulatory capital requirement appears less important.

Keywords: Credit default swaps, firm investment, acquisitions, debt issuance, bankruptcy risk, debt overhang

JEL Classification: G31, G32, G34