The Determinants and Corporate Implications of Credit Derivatives: Evidence from the CDS Market

Financial market participants and regulators are concerned with how and why credit risk (and the ability to hedge it) affects asset prices and investor behavior. In this context, the role played by credit default swap (CDS) contracts has received increasingly more attention. Firstly introduced in 1994, the market for pricing and hedging credit risk through CDS contracts matured after 2000 and has proven to be resilient in the face of several major shocks and corrections. The role played by CDS and other credit derivatives contracts in determining corporate and investors' decisions, or even in triggering financial crises (such as that of 2007-2009), has been hotly debated in the industry as well in academia. At the same time, thanks to its high liquidity and volume, the CDS market represents an invaluable source of information and a readily-available measurement of both corporate and sovereign credit risk.This research plan aims at deepening our understanding of the drivers of credit risk pricing and trading, and its consequence for corporate policies and firm behavior. The plan is organized around three projects. The first project explores differences in the pricing of CDS contracts. In particular, the project exploits the fact that CDS contracts exist for both publicly-listed and privately-held firms. Thus, the CDS market provides a unique setting in which we can analyze how legal form, which in turn implies a different level of availability of public information regarding a firm's finances, impacts the prices of its securities. This is a fundamental issue in finance and economics. Much of the literature, however, focuses on data for equity and corporate bond markets. The CDS market allows us to contrast the prices of CDS contracts (arguably reflecting a component of cost of capital) for comparable firms that only differ on the dimension of how much public information (as summarized by the share price) is available for these firms.The second project relates to how the ability of investors to hedge credit risk affects their behavior. By now, the literature has established that fixed income lenders (such as banks) play an important role in monitoring firms and preventing them from taking unnecessary risks. However, when CDS contracts become available in the marketplace, lenders have an alternative way of protecting themselves and may become reluctant to monitor creditors strictly. In the project we plan to investigate the significance of CDS contract availability for monitoring by firms' lenders. Specifically, equityholders may be induced to step up and become more active in monitoring the firm. Answering this question would shed some light on some ``unintended'' consequences of credit derivative trading, and their effect on corporate control.The third project looks at the whether and how the COVID-19 pandemic induced changes in the relation between credit risk (CDS prices) of government and nonfinancial corporations. By studying spillovers in light of the unprecedented halt in economic activity triggered by the pandemic, the project aims at understanding the role of fiscal slack in public finances in dampening or exacerbating credit shocks for corporations.