Impact of credit default swaps on firms’ operational efficiency

Abstract

As one of the most important financial innovations in the last two decades, credit default swap (CDS) contracts have been initiated and actively traded in the market to hedge against credit risks. However, little is known about how these financial innovations affect an underlying firm's operations. In this empirical study, we find that an underlying firm's operational efficiency is significantly improved with the inception of CDS trading. Our results are robust to multiple causal identification strategies. Further analysis suggests that the inception of CDS tends to enhance the operational efficiency of a firm through the supply chain financing capability and trade credit. We also postulate that CDS leads to enhanced efficiency through institutional monitoring and improvements in management effectiveness. We then obtain suggestive evidence. Our findings have direct implications concerning the ongoing policy debate surrounding CDS. We contribute to operations management research by exploring how innovations in the financial market would, in turn, affect the operational performance of firms. K E Y W O R D Scredit default swaps, financial innovations, institutional monitoring, operational efficiency, supply chain finance "I wish somebody would give me some shred of evidence linking financial innovation with a benefit to the economy."

How do suppliers respond to institutional complexity? Examining voluntary public environmental disclosure in a global manufacturing supply network

“…A corporate logic is centered around concepts of organizational size and status (Thornton et al, 2012). Organizational size is often operationalized using total assets (e.g., Eroglu & Hofer, 2011; Falcone et al, 2023; Jacobs et al, 2010; Laamanen & Keil, 2008; Liu et al, 2009; Luo, Guo, et al, 2019; Qiu et al, 2022; Swift et al, 2019), number of employees (e.g., O'Leary‐Kelly & Flores, 2002; Sila, 2007; Yeung, 2008), and other measures such as sales (e.g., Fullerton et al, 2003; Hendricks & Singhal, 2001), and cost of goods sold (e.g., Barker et al, 2022). We chose to use total assets since it is commonly understood as a proxy for firm size as it represents a stable and objective measure of a firm's financial footprint and it is reported annually in line with regulated financial disclosures – buyer total assets should be closely related to a supplier's attention and positive appraisals if the supplier's decision‐making is shaped by a corporate logic (Ocasio, 1997; Thornton et al, 2012).…”

Covenant violation and operational efficiency

“…Hope et al (2022) find that a government's ability and willingness to gather and disseminate data on local conditions and country fundamentals increase firm operational efficiency in emerging economies. Qiu et al (2022) examine how credit default swap (CDS), a specific form of financial innovation, affects operational efficiency and find that the inception of CDS increases the underlying firm's operational efficiency through the supply chain financing capacity and trade credit.…”

“…It is essential for a firm to achieve high operational efficiency to stay in business and remain competitive. External resources and advantages affect firms' operational efficiency (e.g., Garmaise & Natividad, 2010; Hope et al., 2022; Qiu et al., 2022). For example, Garmaise and Natividad (2010) provide evidence that credit assessments of microfinance institutions (MFIs) by non‐profit rating agencies (a proxy for the exogenous decrease in the asymmetric information about a given MFI) reduce the MFIs' costs of financing and improve their operational efficiency.…”

“…In addition, we add to the emerging literature on operational efficiency (Cheng et al., 2018; Demerjian et al., 2012; Feng et al., 2015; Imdieke et al., 2023; Qiu et al., 2022). Prior studies show that lower information risk leads to higher operational efficiency (Cheng et al., 2018; Imdieke et al., 2023).…”

“…Feng et al (2015) find that poorer inventory management and firm operations can result from inventory-related material weaknesses in internal control over financial reporting. Moreover, managerial ability (Demerjian et al, 2012), supply chain financing capacity (Qiu et al, 2022) and risk disclosure (Derouiche et al, 2021) affect operational efficiency. We document that enhanced creditor control rights post covenant violation decrease violating firms' operational efficiency.…”