Credit default risk for an obligor can be hedged with either a credit default swap (CDS) or a constant maturity credit default swap (CMCDS). We find strong evidence of persistent differences in the hedging cost associated with the two comparable contracts. Between 2001 and 2006, it would have been more profitable to sell CDS and buy CMCDS while after the crisis between 2008 and 2013 the opposite strategy was profitable. Panel data tests indicate that for our sample period the implied forward CDS rates are unbiased estimates of future spot CDS rates. The changes in the company implied volatility is the main determinant of trading inefficiencies, followed by the changes in GDP and in the interest rates before the crisis, and the changes in sentiment index and in the VIX after the crisis

We offer the first empirical evidence on the adverse effect of credit default swap (CDS) coverage on subprime mortgage defaults. Using a large database of privately securitized mortgages, we find that higher defaults concentrate in mortgage pools with concurrent CDS coverage, and within these pools the loans originated after or shortly before the start of CDS coverage have an even higher delinquency rate. The results are robust across zip code and origination quarter cohorts. Overall, we show that CDS coverage helped drive higher mortgage defaults during the financial crisis

In this paper, we analyze the determinants and effects of credit default swap (CDS) trading initiation in the sovereign bond market. CDS trading initiation is associated with a 30–150 basis point reduction in sovereign bond yields, with greater yield reductions accruing to higher default risk economies. For countries with high default risk, rated B or lower by Standard and Poor’s, CDS initiation is also associated with significant price efficiency benefits in the underlying market. CDS trading initiation is more likely following increases in local equity index volatility, index spreads for regional and global CDS markets, or depreciation of the local currency relative to the US dollar, and decreases in a country’s ability to service foreign debt. Our results are robust to selection bias controls based on these factors

We provide a model of nonredundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: it crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs

We provide a model of nonredundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: it crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs

This article provides evidence that equity returns lead credit protection returns at daily and weekly frequencies, whereas credit protection returns do not lead equity returns. Our results indicate that informed traders are primarily active in the equity market rather than the credit default swap (CDS) market. These findings are consistent with standard theories of market selection by informed traders in which market selection is determined partially by transaction costs. We also find that credit protection returns respond more quickly during salient news events (earnings announcements) compared to days with similar equity returns and turnover. This evidence provides support for explanations related to investor inattention

This paper investigates whether the initiation of trading in credit default swaps (CDSs) on a borrowing firm׳s outstanding debt is associated with a decline in that firm׳s reporting conservatism. CDS investments can modify lenders׳ payoffs on their loan portfolios by providing insurance on negative credit outcomes. The onset of CDS trading reduces lenders׳ incentives to continuously monitor borrowers and also their demand that borrowers report conservatively. Additionally, borrowers expect CDS-insured lenders to be more intransigent in renegotiations triggered by defaults and covenant violations. Since conservatism can trigger earlier covenant violations, borrowers have heightened incentives to report less conservatively in the post-CDS period. Using a differences-in-differences research design, we observe a decline in borrowing firms׳ reporting conservatism after CDS trade initiation. This effect is more pronounced when reputation costs lenders face from reducing monitoring are lower, when debt contracts outstanding at the time of CDS trade initiation have more financial covenants, and when lenders who monitor borrowers more regularly in the pre-CDS period enter into CDS contracts to hedge their credit exposures

This article studies the connection between risk taking and executive compensation in financial institutions. A model of shareholders, debtholders, depositors, and an executive demonstrates that (i) excess risk taking can be addressed by basing compensation on both stock price and the credit default swaps (CDS) spread, (ii) shareholders may not be able to commit to design such contracts, and (iii) they may not want to due to distortions from deposit insurance or unobservable tail risk. The advantage of using the CDS spread rather than deferred compensation or debt is due to the fact that it is a market price and reduces agency costs

We document that equity markets become less liquid and equity prices become less efficient when markets for single-name credit default swap (CDS) contracts emerge. This finding is robust across a variety of market quality measures. We analyze the potential mechanisms driving this result and find evidence consistent with negative trader-driven information spillovers that result from the introduction of CDS. These spillovers greatly outweigh the potentially positive effects associated with completing markets (e.g., CDS markets increase hedging opportunities) when firms and their equity markets are in “bad” states. In “good” states, we find some evidence that CDS markets can be beneficial

We investigate the information contained in the London Interbank Offered Rate (LIBOR) and the U.S. Constant Maturity Treasury (CMT) term structure of interest rates and report three novel findings. First, we document that the information contained in term structures are significantly different from one another. Second, we provide evidence of a significant change in the nature of this difference as the financial crisis began. Third, we find that the significant changes in the information content of CMT and LIBOR are consistent with significant shocks to credit default swap rates and tenor swap rates