"Less is More": Credit Default Swaps and Firm Cyclicality

Abstract

Firm cyclicality, measured as firm asset growth-GDP growth sensitivity, decreases by around 40% after the inception of credit default swap (CDS) trading. The effect is mainly observed in good times and stronger for firms facing a more severe exacting creditor problem. The cyclicality-reducing effect of CDS trading cannot be explained with bank lending cyclicality or market beta. Our finding is robust for alternative measures such as outstanding CDS positions, firm employment growth, and state-/industry level cyclicality. Moreover, CDS trading impedes unhealthy firm growth and enhances profitability and firm value. Overall, our paper reveals a new real effect of financial innovations on firm cyclicality and highlights an important disciplining effect of CDS on corporate growth.

Keywords: Credit default swaps, real effects of financial markets, exacting creditors, asset growth, employment growth

JEL Classification: G32, G33, G34