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Credit Default Swaps, Strategic Default, and the Cost of Corporate Debt

Author:
Gi H. Kim  


Issue Date:
2013


Abstract(summary):

In this paper, I provide the evidence of credit default swaps (CDS, hereafter) playing new economic roles as a commitment device for the borrower (i. e. the firm) to repay its debt to the lender (i. e. the creditors). When the firm writes incomplete debt contracts, its limited ability to commit not to default strategically in the future incurs the cost of contracting that will be ulti- mately paid by the firm. CDS can reduce this cost ex ante by strengthening creditors' bargaining power in distressed debt renegotiation. I identify, both theoretically and empirically, the benefit of CDS reducing the contracting cost arising from the possibility of strategic default. More specifically, I show that firms a priori most likely to face the limited commitment prob- lem (i. e. firms with high strategic default incentives) experience a relatively larger reduction in their corporate bond spreads following the introduction of CDS.


Page:
51


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