Credit Default Swaps and Debt Overhang
43 Pages Posted: 28 Apr 2017 Last revised: 20 Dec 2019
Date Written: December 19, 2019
We analyze the impact of credit default swaps (CDS) trading on firm investment, long-term debt financing, and valuation. In our model, the firm is endowed with a real option to initiate a project and enhance its future growth. Its creditors have access to CDS contracts that hedge them against default losses. We find that CDS trading increases debt capacity. However, at the same time it decreases asset growth and impedes project initiation. As a result, CDS trading could reduce firm value, and the negative effects are stronger when the firm is riskier, where shareholders have stronger bargaining power, and growth opportunities are less valuable.
Keywords: Credit Default Swaps, Debt Overhang, Investment, Empty Creditor, Credit Risk
JEL Classification: G31, G33, G34
Suggested Citation: Suggested Citation