The Real Effects of Credit Default Swaps

We examine the effect of introducing credit default swaps (CDSs) on firms’ investment and financing policies. Our model allows for dynamic investment and dynamic financing using equity and debt, and debt holders can trade in the CDS market. After calibrating the model, we compare an economy with a CDS market to an economy without one. The model contains both positive and negative effects of CDS contracts. While they reduce the risk of strategic default, they also increase the probability of bankruptcy. The first effect dominates, which leads to higher leverage, investment, and firm value. The effect on firm value is strongest for small and high growth firms.

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