Credit Default Swaps, Firm Financing and the Economy

Murillo Campello, Rafael Matta
2012 Social Science Research Network  
We develop a model in which investment risk drives the demand for CDS insurance. We show that CDS overinsurance (insurance in excess of renegotiation proceeds) is procyclical and allows for greater financing of firms with positive NPV projects. In bad times, CDS overinsurance triggers the early liquidation of firms with low continuation values. Our analysis explains the benefits of CDS contracting over economic cycles and reconciles evidence showing that CDSs are most beneficial for firms that
more » ... ial for firms that are safer and have higher continuation values. The model generates a number of empirical predictions and provides insights on the regulation of CDS markets. Abstract We develop a model in which investment risk drives the demand for CDS insurance. We show that CDS overinsurance (insurance in excess of renegotiation proceeds) is procyclical and allows for greater financing of firms with positive NPV projects. In bad times, CDS overinsurance triggers the early liquidation of firms with low continuation values. Our analysis explains the benefits of CDS contracting over economic cycles and reconciles evidence showing that CDSs are most beneficial for firms that are safer and have higher continuation values. The model generates a number of empirical predictions and provides insights on the regulation of CDS markets.
doi:10.2139/ssrn.1770066 fatcat:lr7rsj4yqnct3jula7cqskque4