Credit Default Swaps in General Equilibrium: Endogenous Default and Credit Spread Spillovers
60 Pages Posted: 30 May 2013 Last revised: 26 Aug 2022
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Credit Default Swaps in General Equilibrium: Endogenous Default and Credit Spread Spillovers
Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default
Date Written: January 25, 2018
Abstract
This paper shows that credit default swaps (CDS) can affect the type of debt firms issue. Firms face a trade-off between investment scale and the cost of capital measured by the credit spread. Small-scale investment is safe, fully collateralized, but earns modest profits in all states. Large-scale investment is risky, requires a positive credit spread, but yields high profits only in good states and default in bad states. CDS only affect risky credit spreads, which in turn affects the opportunity cost of issuing collateralized, safe debt. Covered (Naked) CDS lower (raise) credit spreads and raise (lower) the likelihood of issuing risky debt. Lastly, we show that CDS generate credit spread and investment spillovers for non CDS-referenced firms.
Keywords: credit derivatives, borrowing costs, spillovers, investment, default risk
JEL Classification: D52, D53, E44, G10, G12
Suggested Citation: Suggested Citation
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