Credit Market Speculation and the Cost of Capital

Che, Yeon‐Koo; Sethi, Rajiv

doi:10.1257/mic.6.4.1

Cited by 43 publications

(44 citation statements)

References 27 publications

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“…As discussed earlier, firms' borrowing costs may be higher due to decreased monitoring after CDS trading (Ashcraft and Santos, 2009;Che and Sethi, 2014), which further increases their precautionary cash savings. Therefore, the monitoring mechanism can affect the firms' cash holdings through both increased risk taking (implying a decrease in cash holdings) and increased borrowing costs (implying an increase in cash holdings).…”

Section: Bank-loan Dependencymentioning

confidence: 98%

“…8 The weakened monitoring of the firm after CDS trading may further affect its cost of debt (Ashcraft and Santos, 2009;Che and Sethi, 2014), and increases its precautionary cash holdings. Given the importance of bank lenders in monitoring, the increase in the firm's cash holdings due to decreased monitoring and increased borrowing costs should be more relevant for firms with bank debt.…”

Section: Hypothesis 1 (Cds Exacting Creditors and Cash Holdings) If mentioning

confidence: 99%

“…For instance, internal governance may be strengthened to compensate for the lack of monitoring by creditors. Moreover, weakened monitoring may further affect the cost of debt (Ashcraft and Santos, 2009;Che and Sethi, 2014), which increases precautionary cash savings. In this section, we investigate the mechanisms of CDS effects and compare the ex ante and ex post effects of empty creditors based on the tension in the relationship between cash holdings and CDS trading.…”

Section: Mechanisms and Sources Of Cashmentioning

confidence: 99%

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Credit Default Swaps and Corporate Cash Holdings

2014

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We investigate the liquidity management of firms following the inception of credit default swaps (CDS) markets on their debt, which allow hedging and speculative trading on credit risk to be carried out by creditors and other parties. We find that reference firms hold more cash after CDS trading commences on their debt. The increase in cash holdings is more pronounced for CDS firms that do not pay dividends and have a higher marginal value of liquidity. For CDS firms with higher cash flow volatility, these increased cash holdings do not entail higher leverage. Overall, our findings are consistent with the view that CDS-referenced firms adopt more conservative liquidity policies to avoid negotiations with more exacting creditors.JEL classification: G32.

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Section: Bank-loan Dependencymentioning

confidence: 98%

Section: Hypothesis 1 (Cds Exacting Creditors and Cash Holdings) If mentioning

confidence: 99%

Section: Mechanisms and Sources Of Cashmentioning

confidence: 99%

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Credit Default Swaps and Corporate Cash Holdings

2014

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“…Instead of holding the contract, a speculator can also trade it, i.e., buy it for a short time, withdraw from the contract by selling it to another investor, enter into another contract with another entity, etc. A detailed model of speculation with CDS and its impact on the cost of the debt for the borrower is given, i.e., in Che and Sethi (2015).…”

Section: Cds Market Participants and Usage Of The Instrumentsmentioning

confidence: 99%

The leverage effect puzzle: the case of European sovereign credit default swap market

Kliber

2016

Rev Deriv Res

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One of the stylized facts about the behaviour of time series is that their volatility exhibits asymmetrical responses to good and bad news. In the case of stock markets, volatility seems to rise when the stock price decreases and fall when the stock price increases. This so-called "leverage effect" was first described by Black (Proceedings of the 1976 meeting of the business and economic statistics section, pp [177][178][179][180][181] 1976). The concept is not new and has already been comprehensively studied and implemented in many volatility models (GARCH and SV) in the form of an additional parameter in the volatility equation. However, there is no study or a theoretical explanation of the leverage effect in sovereign credit default swap spreads (hereinafter: sCDS). In this article, we discuss the possible behaviour of sCDS volatility and explain it by way of reference to the Prospect Theory by Kahneman and Tversky (Econometrica 47(2): 1979). We estimate a series of stochastic volatility models with the leverage effect, proposed by Yu (J Econom 127(2): [165][166][167][168][169][170][171][172][173][174][175][176][177][178] 2005). In this model, the "leverage effect" is, in fact, the same as a coefficient of the correlation between the current return of an asset and its expected future volatility. We show that the effect does exist and differs across markets. As far as the safe European markets are concerned, the parameter is negative; in the case of extremely risky economies-it is positive. In markets of medium risk the effect varies depending on the relationship between the perceived risk and the value of the sCDS premium.

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“…Che and Sethi (2014) theoretically show that the CDS market benefits borrowers by increasing their debt capacity and lowering interest rates in the case when CDS can only be purchased against an insurable interest. However, since the CDS market provides lenders with an alternative venue to trade credit risk (Oehmke and Zawadowski (2014a)), lenders may also be less willing to extend credit to the firm if investors are allowed to hold naked CDS positions, i.e., they are CDS buyers who have no exposure to the underlying borrower so that they have no insurable interest.…”

Section: On This Topicmentioning

confidence: 99%

Credit Default Swaps: A Survey

et al. 2014

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Credit default swaps (CDS) have been growing in importance in the global financial markets. However, their role has been hotly debated, in industry and academia, particularly after the credit crisis of 2008-2009 and the European sovereign crisis of 2010-2012. We review the extant literature on CDS that has accumulated over the past two decades. We divide our survey into seven topics after providing a broad overview in the introduction. The second section traces the historical development of CDS markets and provides an introduction to CDS contract definitions and conventions. The third section discusses the pricing of CDS, from the perspective of no-arbitrage principles as well as from that of structural and reduced-form credit risk models. It also summarizes the literature on the determinants of CDS spreads, with a focus on the role of fundamental credit risk factors, liquidity and counterparty risk. The fourth section discusses how the development of the CDS market has affected the characteristics of the related bond and equity markets, with an emphasis on the closely related concepts of market efficiency, price discovery, information flow and liquidity. Attention is also paid to the CDS-bond basis, the wedge between the pricing of the CDS and its reference bond, and the mispricing between the CDS and the equity market, which leads to a discussion on capital structure arbitrage. The fifth section examines the effect of CDS trading on firms' credit and bankruptcy risk, and how it affects corporate financial policy, including bond issuance, capital structure, liquidity management, and both external and internal corporate governance. The sixth section summarizes the literature that takes into account how CDS may impact the incentives of the various agents in the economy and the associated impact on the pricing of the contracts. In particular, we examine how CDS may alter the debtor-creditor relationship. Section seven reviews the growing literature on sovereign CDS and highlights the major conceptual and contractual differences between the sovereign and corporate CDS markets. In section eight, we discuss CDS indices, especially the role of synthetic CDS index products backed by residential mortgage-backed securities during the financial crisis. We close with our suggestions for promising future research directions on CDS contracts and markets.

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Credit Market Speculation and the Cost of Capital

Cited by 43 publications

References 27 publications

Credit Default Swaps and Corporate Cash Holdings

Credit Default Swaps and Corporate Cash Holdings

The leverage effect puzzle: the case of European sovereign credit default swap market

Credit Default Swaps: A Survey

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