The real effects of credit default swaps

Abstract

We examine the effect of introducing credit default swaps (CDSs) on firm value. Our model allows for dynamic investment and financing, and bondholders can trade in the CDS market. The model incorporates both negative and positive effects of CDSs. CDS markets lead to more liquidations, but they also reduce the probability of costly debt renegotiation and reduce costly equity financing. After calibrating the model, we find that firm value increases by 2.9% on average with the introduction of a CDS market. Firms also invest more and increase leverage. The effect on firm value is strongest for small, financially constrained, and low productivity firms.