Leverage represents both a fundamental component of equity volatility and a long-run selection variable. Based on this premise, we investigate the influence of leverage on the long-run cross-sectional predictability of future realized equity volatility. Leverage makes equity volatility significantly less predictable than underlying firm asset volatility, a result that is robust to different predictors of future realized volatility: credit default swap implied, historical, and option implied volatility. A simple model of optimal capital structure, wherein companies maximize tax benefits subject to a common maximum default probability (minimum credit rating) target, helps explain this finding

In this paper, we examine the effect of credit defaults swaps (CDS) initiation on reference firms' cost management strategies. CDS contracts provide insurance protection for creditors, inducing a shift in bargaining power from borrowers to creditors and an excessive incidence of bankruptcy. Anticipating more intransigent creditors in debt renegotiations and higher bankruptcy risk, CDS firms are incentivized to mitigate risk through decreasing cost stickiness after CDS initiation, as cost stickiness lowers liquidity and triggers early covenant violations. We find that, on average, CDS initiation is associated with a decline in reference firms' cost stickiness. This association is more pronounced for less liquid, financially distressed, and lower credit quality firms. We also find that CDS firms with a reduction in cost stickiness will exhibit lower future bankruptcy risk than CDS firms without such as reduction in stickiness. Collectively, our findings suggest that the CDS-induced “empty creditor problem” causes reference firms to undertake more conservative cost management practices to alleviate downside risk

We examine the effect of voluntary climate risk disclosure on Credit Default Swap (CDS) premiums. We develop a structural model, in which climate-related disclosures serve as an information source reducing climate change uncertainty. The model predicts a negative relation between the informativeness of climate risk disclosure and the CDS premium, and asymmetric effects of positive and negative disclosure tone on the CDS premium. Using climate risk measures quantified from earnings call transcripts, we provide evidence supporting these predictions with causal inference. Our study suggests that climate risk is priced in the CDS market, where investors pay attention to climate risk disclosures

The sovereign debt crisis in the euro area highlighted the close connections between the financial health of banks and sovereigns and was associated with higher funding costs and lower private sector credit. In this study, we analyze the dynamics of the co-movement between sovereign and bank credit default swaps (CDS) spreads in five sub-periods over 2010–2018 and evaluate the effects of the announcement and introduction of the Single Resolution Mechanism (SRM). Our evidence demonstrates that the new bail-in regime, which ensures that troubled banks' private debtholders absorb their losses first, before public money could be used to bail them out, significantly reduced the interconnections between sovereign and banking sector risks

From 2005 to 2015, the 25 largest global financial institutions paid combined more than $285 billion in legal penalties. We examine the reaction of banks' stocks, bonds, and credit default swaps to the announcements of monetary penalties. We observe a reduced default risk and lower financing costs, as well an increase in the stock market valuation, suggesting that banks benefit from settling lawsuits. The positive reaction is likely driven by the resolution of uncertainty surrounding these proceedings. While the sued bank's systemic risk increases in the size of the relative monetary penalty, we also document positive spillover effects to other banks facing pending lawsuits with the same plaintiff, demonstrating the systemic effect of law enforcement against banks. Furthermore, banks appear to correctly anticipate penalties, as they are cash flow-effective but not income-effective in the year they are announced