Credit Default Swaps in General Equilibrium: Spillovers, Credit Spreads, and Endogenous Default

Abstract

This paper highlights two new effects of credit default swap markets (CDS) in a general equilibrium setting. First, when firms' cash flows are correlated, CDSs impact the cost of capital{credit spreads{and investment for all firms, even those that are not CDS reference entities. Second, when firms internalize the credit spread changes, the incentive to issue safe rather than risky bonds is fundamentally altered. Issuing safe debt requires a transfer of profits from good states to bad states to ensure full repayment. Alternatively, issuing risky bonds maximizes profits in good states at the expense of default in bad states. Profits fall when credit spreads increase, which raises the opportunity cost of issuing risky debt compared to issuing safe debt. Symmetrically, lower credit spreads reduce the opportunity cost of issuing risky debt relative to safe debt. CDSs affect the credit spread at which firms issue risky debt, and ultimately the opportunity cost of issuing defaultable bonds even when underlying firm fundamentals remain unchanged. Hedging (Speculating on) credit risk lowers (raises) credit spreads and enlarges (reduces) the parameter region over which firms choose to issue risky debt.