We derive a model with qualitative implications for options pricing under counterparty credit risk and provide empirical evidence using the data from the Hong Kong derivatives market during 2005–2014. We find that the log-price difference between a derivative warrant with counterparty credit risk and an otherwise identical option without counterparty credit risk is significantly and negatively associated with the credit default swap spread on the warrant issuer. We also find that the prices of out-of-the-money put warrants are more sensitive to credit risk than those of other warrants. Our results show counterparty credit risk matters for derivative pricing

Credit default swaps (CDSs) can create empty creditors who potentially force borrowers into inefficient bankruptcy but also reduce shareholders’ incentives to default strategically. We show theoretically and empirically that the presence and the effects of empty creditors on firm outcomes depend on the distribution of bargaining power among claimholders. If creditors would face powerful shareholders in debt renegotiation, firms are more likely to face the empty creditor problem. The empirical evidence confirms that more CDS insurance is written on firms with strong shareholders and that CDSs increase the bankruptcy risk of these same firms. The ensuing effect on firm value is negative

Credit `default swaps (CDS) represent a major innovation in debt markets, allowing lenders to transfer credit risk to a counterparty by paying a premium. Shan, Tang, and Winton (2019) explore whether the availability of CDS affects the monitoring incentives of lenders. Their paper finds that CDS leads to looser loan terms (less collateral and looser covenants), consistent with a reduction in monitoring incentives. I examine several aspects of their study, including whether loan provisions and CDS should serve the same purpose, and differences between CDS and non-CDS borrowers. In total, although the authors present empirical evidence consistent with their prediction, the sample selection and research design potentially limit the generalizability of the authors’ results

Using proprietary credit default swap (CDS) data, I investigate how capital shocks at protection sellers impact pricing in the CDS market. Seller capital shocks—measured as CDS portfolio margin payments—account for 12% of the time‐series variation in weekly spread changes, a significant amount given that standard credit factors account for 18% during my sample. In addition, seller shocks possess information for spreads that is independent of institution‐wide measures of constraints. These findings imply a high degree of market segmentation, and suggest that frictions within specialized financial institutions prevent capital from flowing into the market at shorter horizons

We construct a novel dataset that matches bank holding company credit default swap (CDS) positions to detailed U.S. credit registry data containing both loan and corporate bond holdings by large U.S. banks. The dataset sheds new light on how banks use CDS, and what effects, if any, CDS use has on corporate credit risk. We show that few banks insure loans, even loans of distressed borrowers, suggesting that empty creditor problems among banks are not widespread. We find that banks are more likely to sell than buy CDS when they have a lending relationship with CDS firms. We then create new aggregate measures of hedging activity based on position-level data to test the empty creditor hypothesis. Contrary to existing studies, aggregate measures of credit risk hedging that do not condition on lending relationships overstate bank hedging activity. Furthermore, our regression results do not find any evidence that firm credit risk is adversely impacted when banks in particular purchase CDS

This paper provides evidence of the impact of the new European bank resolution regime on the sovereign-bank nexus. The implementation of the Bank Recovery and Resolution Directive (BRRD) is considered as an exogenous shock which provides the setting for a natural experiment. This investigation tests the financial markets’ perception of the effectiveness of the new rules in weakening the tight interconnectedness between sovereign and bank risk. A Difference-in-Differences (DiD) approach is adopted, building evidence from the Credit Default Swap (CDS) market for banks and non-financial corporates over the period 2011-18. The main findings do not indicate a significant weakening in the interaction between bank and sovereign CDS spreads, compared to the corresponding evidence for the non-financial corporate sector. An overall narrowing of the gap between bank and sovereign risk occurs, which initially implies a lack of credibility of the BRRD in financial markets. However, substantial cross-country variations are identified, particularly for Italy and non-euro area countries. These insights make a significant contribution to the policy debate on effective regulation of the sovereign-bank nexus, in the light of recent developments in the EU post-crisis reform agenda

Financial regulation is harmonized across countries even though countries vary in their ability to bail-out their banking sector in the event of a crisis. This article addresses the question of whether countries with different fiscal capacity should optimally have different bank regulation, implemented—among other tools—through capital requirements—a question so far ignored by the theoretical banking literature. I show that countries with larger fiscal capacity should have lower ex ante minimum bank capital requirements, in an environment with endogenously incomplete markets and overinvestment due to “Too-Big-To-Fail” moral hazard and pecuniary externalities. I also show that, in addition to a minimum bank capital requirement, regulators in countries with strong “Too-Big-To-Fail” moral hazard should impose a limit on the liabilities pledged by financial institutions in a crisis state. This implies limits on put options/credit default swap contracts. Finally, I argue that the type of regulatory instrument used is crucial as to whether larger fiscal capacity implies more- or less-stringent bank regulation