Credit Default Swaps and Debt Overhang

43 Pages Posted: 28 Apr 2017 Last revised: 20 Dec 2019

See all articles by Tak-Yuen Wong

Tak-Yuen Wong

National Tsing Hua University - Department of Quantitative Finance

Jin Yu

Monash University -Department of Banking and Finance

Date Written: December 19, 2019

Abstract

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

Wong, Tak-Yuen and Yu, Jin, Credit Default Swaps and Debt Overhang (December 19, 2019). 30th Australasian Finance and Banking Conference 2017, Available at SSRN: https://ssrn.com/abstract=2959302 or http://dx.doi.org/10.2139/ssrn.2959302

Tak-Yuen Wong (Contact Author)

National Tsing Hua University - Department of Quantitative Finance ( email )

101, Section 2, Kuang-Fu Road
Hsinchu, Taiwan 300
Taiwan

HOME PAGE: http://https://sites.google.com/site/etywong110/

Jin Yu

Monash University -Department of Banking and Finance ( email )

Melbourne
Australia
+61 3 99034590 (Phone)

HOME PAGE: http://sites.google.com/site/jinyufinecon/

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