The impacts of credit default swaps on debt pricing, corporate investment and dividend policy

• Main Author: Wu, Yulin
• Other Authors: Newton, David
• Published: University of Bath 2018
• Online Access: https://ethos.bl.uk/OrderDetails.do?uin=uk.bl.ethos.767580

This thesis seeks to answer how the availability of credit default swaps (CDSs) affects the economy and its participants. As a sort of financial innovation, CDSs transfer default risk among investors. For each transaction, the CDS buyer pays the seller a premium and, in exchange, receives compensation if a specified credit event happens. In the process, the risk taker has been changed. This alteration subtly affects the incentives of creditors and borrowers and the underlying economic logic merits better understanding. Our research firstly explores the impact of credit default swaps on the yield spread between corporate and Treasury bonds. Since CDSs can affect debt pricing in both negative and positive ways, we attempt to separate these two opposite forces. Using both theoretical and empirical approaches, we show how firm-specific CDSs affect the yield spread under different bond issuing conditions. Specifically, we find that the aggregate CDS effect depends on firms' credit strengths when bonds are issued and the yield spread shrinks (expands), after the start of CDS trading, with good (poor) firm credit. The second motivation of this thesis is to investigate changes in a firm's investment and its investment-cash flow sensitivity following the introduction of CDS trading. We find that reference firms reduce their investments, on average, after introducing credit default swaps and their investment-cash flow sensitivities increase simultaneously. However, these effects are dependent on firms' qualities. For firms with high liquidity or integrity, investments are increased and they rely less on cash flows while firms with low liquidity or integrity cut down investments and exhibit higher dependence. Finally, we extend our research to the CDS effects on corporate dividend policy, the signaling role of dividends and stock responses to dividend announcements. As vehicles for transferring risk, CDSs weaken third-party protection for minority shareholders. This, in turn, can affect managers' incentives and the setting of dividend policy. We find that firms are more likely to pay, increase and continue to pay dividends after their debts are referenced by CDSs especially for firms with higher free cash flows, older firms and larger firms. The connotation changes too: the relationship between dividends and future earnings growth is weakened following the initiation of a CDS market.