Who owns credit default swaps

Table of Contents Expand. How Credit Default Swaps Work. Hedging and Speculation. Market Risks. The Bottom Line. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.

We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation.

This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Articles. Partner Links. Reference Equity Definition Reference equity is the underlying asset that an investor is seeking price movement protection for in a derivatives transaction. Reference Asset A reference asset, also known as a reference obligation, is an underlying asset used in credit derivatives.

Credit Default Insurance Credit default insurance is a financial agreement to mitigate the risk of loss from default by a borrower or bond issuer. Investopedia is part of the Dotdash publishing family. While credit risk hasn't been eliminated through a CDS, risk has been reduced. For example, if Lender A has made a loan to Borrower B with a mid-range credit rating , Lender A can increase the quality of the loan by buying a CDS from a seller with a better credit rating and financial backing than Borrower B.

The risk hasn't gone away, but it has been reduced through the CDS. If the debt issuer does not default and if all goes well, the CDS buyer will end up losing money through the payments on the CDS, but the buyer stands to lose a much greater proportion of its investment if the issuer defaults and if it had not bought a CDS.

As such, the more the holder of a security thinks its issuer is likely to default, the more desirable a CDS is and the more it will cost. Any situation involving a credit default swap will have a minimum of three parties. The first party involved is the institution that issued the debt security borrower. The debt may be bonds or other kinds of securities and are essentially a loan that the debt issuer has received from the lender.

Yet, because the debt issuer cannot guarantee that it will be able to repay the premium, the debt buyer has taken on risk. The debt buyer is the second party in this exchange and will also be the CDS buyer, if the parties decide to engage in a CDS contract. The third party , the CDS seller, is most often a large bank or insurance company that guarantees the underlying debt between the issuer and the buyer.

This is very similar to an insurance policy on a home or car. CDS are traded over-the-counter OTC —meaning they are non-standardized and not verified by an exchange—because they are complex and often bespoke. There is a lot of speculation in the CDS market, where investors can trade the obligations of the CDS if they believe they can make a profit. The company that originally sold the CDS believes that the credit quality of the borrower has improved so the CDS payments are high.

The company could sell the rights to those payments and the obligations to another buyer and potentially make a profit. Alternatively, imagine an investor who believes that Company A is likely to default on its bonds.

The investor can buy a CDS from a bank that will pay out the value of that debt if Company A defaults. A CDS can be purchased even if the buyer does not own the debt itself. This is a bit like a neighbor buying a CDS on another home in her neighborhood because she knows that the owner is out of work and may default on the mortgage. Although credit default swaps can insure the payments of a bond through maturity, they do not necessarily need to cover the entirety of the bond's life.

For example, imagine an investor is two years into a year security and thinks that the issuer is in credit trouble. The bond owner may choose to buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will have faded. It is even possible for investors to effectively switch sides on a credit default swap to which they are already a party.

For example, if a CDS seller believes that the borrower is likely to default, the CDS seller can buy its own CDS from another institution or sell the contract to another bank in order to offset the risks. The chain of ownership of a CDS can become very long and convoluted, which makes tracking the size of this market difficult.

Credit default swaps were widely used during the European Sovereign Debt crisis. Many hedge funds even used CDS as a way to speculate on the likelihood that the country would default. Klapper and Love present evidence that firm-level corporate governance matters more in countries that have relatively weak legal environments.

Christensen, Hail, and Leuz examine changes in EU market regulation across European countries and find significant differences in the effect of these directives, with liquidity benefits stronger in countries that have stricter implementation and enforcement of rules, as well as higher-quality regulatory procedures. Overall, these papers and other research that followed provide strong evidence that the legal environment is an important determinant of the characteristics of capital markets, whether and how firms access these markets, and the structure and effects of corporate governance inside firms.

In this paper, we contribute to this literature on law and finance by empirically analyzing the impact of the introduction of credit default swaps CDSs on a cross-country sample of firms.

This setting offers significant advantages when analyzing the effect of the legal environment on the firm. Existing research argues that the introduction of CDSs can significantly affect decisions made by the firm; given the mechanisms described in these papers, this impact crucially depends on the legal and market environment that the firm faces. In addition, although models suggest that the impact of CDS introduction may differ substantially across countries, existing empirical work has examined these effects primarily in North American firms.

In sharp contrast, we examine whether cross-country differences in institutional structures, particularly with regard to the legal codes governing the firm, influence the impact of the introduction of CDS trading on the underlying corporate financial policies.

Our results provide insight into the importance of specific aspects of the legal environment for key economic quantities, such as the capital structure of firms. Indeed, the results of existing work suggest that, at the country level, creditor rights and the quality of the legal system are important determinants of the depth of credit markets.

In contrast, a decrease in the quality of the legal system, measured by the number of days that contract enforcement requires, is associated with a significant decrease in the ratio of private credit to GDP. In the limit, an individual who holds both CDS and the underlying debt may have little or no interest in the efficient continuation of the firm see, e.

This uncertainty captures differences in the way that local bankruptcy codes interact with the standardized definitions of CDS contract terms established by the International Swaps and Derivatives Association ISDA.

If there is less uncertainty that a particular action will trigger payments related to CDSs, the environment is considered more creditor friendly. For plausible parameter values, we demonstrate that the introduction of CDSs increases debt capacity more in regimes with less uncertainty regarding credit events. The intuition is similar to that of Bolton and Oehmke : well-functioning credit derivative contracts, such as CDSs, can allow firms to overcome limited-commitment problems that arise due to weak institutional heritages.

However, these benefits are larger when there is less uncertainty about the enforcement of obligations due under the swap contracts. We conduct our empirical analysis using a sample of more than 56, firms from 51 countries during the period — The use of an international sample provides us with cross-sectional variation in the legal environment, particularly creditor rights, which may influence the effect of the introduction of CDSs.

Existing theory implies that these features of the legal and market environment can be important determinants of the effects of CDS introduction, and a global sample may allow for better inferences about whether these variables play a significant role in those effects. To our knowledge, this research is the first to empirically analyze the consequences of CDS trading for nonfinancial firms in a global context Therefore, it also provides the first detailed, large-scale, out-of-sample evidence for the effect of CDSs on corporate financial policies beyond prior U.

An analysis of the effects of CDS introduction must, by necessity, consider endogeneity biases, since CDS introduction is not random. We address these concerns using a relatively new econometric technique that has not previously been used in the finance literature.

Although we use a wide array of covariates, we also conduct a sensitivity analysis to examine whether our results are affected by omitted variable bias. Our results indicate that after CDS introductions the underlying firms increase leverage in countries that have stronger creditor rights along specific dimensions. The first dimension is the requirement for creditor consent in order to enter reorganization, which can act as a trigger for CDS obligations.

The second dimension that influences the impact of CDS introduction is the requirement that secured creditors be paid first out of liquidation proceeds. This indicates that leverage increases are greater when liquidation costs are low, particularly when ex post excessive liquidation pressure may come from empty creditors with CDS protection. We also find that underlying firms increase leverage more in countries with weaker contract enforceability, and if their equity ownership is more concentrated, as shareholders would have greater bargaining power.

These results indicate that the introduction of CDSs can act as a substitute for weak property rights, especially in situations in which poor enforceability of property rights is a constraint on the supply of credit in the domestic capital market.

This is consistent with the finding of Bae and Goyal that, along with creditor rights, property rights are an important determinant of the credit available to firms. In addition, newly introduced CDS contracts effectively enhance the debt capacity of underlying reference entities when creditors initially have an inferior bargaining position with respect to majority shareholders Davydenko and Strebulaev , who would have more bargaining power during private debt renegotiation in the absence of CDSs.

We perform a number of robustness checks on our results. In addition to the sensitivity analysis of omitted variables mentioned above, these tests include the use of additional control variables; a test of the conditional independence of our treatment assignment using alternative ordinary least squares OLS estimations; the use of CDS existence rather than CDS introduction as the variable of interest; an analysis of a subsample that excludes U.

The results from these tests remain qualitatively and quantitatively similar. These results show that the interaction between CDS contracts and local bankruptcy codes also influences the investment policies of firms. While financial derivatives have been around for more than three decades, CDS are a much more recent phenomenon.

Given the role of CDSs in the recent financial crisis Stulz , the existing literature has focused primarily on their role with regard to financial institutions. Similarly, the European sovereign debt crisis has triggered interest in using CDS to study sovereign risk see, e. In contrast, while an extensive literature has investigated the use of derivatives on currencies, interest rates, and commodity prices by nonfinancial firms and the underlying frictions that justify their existence see, e. Rather, some of their claimholders e.

Nevertheless, a developing, relatively recent literature suggests that CDS may still affect various corporate policies of the underlying firms. Although CDS are, in theory, redundant derivative assets, existing research indicates that market frictions related to these contracts are nontrivial, and hence that the introduction of CDSs can have significant effects on security prices, economic incentives, and investor and firm behavior.

CDSs can clearly provide better hedging opportunities for lenders, but these opportunities may be associated with inefficiencies, such as excessive liquidation, reduced monitoring by lenders, and increased losses to creditors in default.

However, by improving creditor rights, CDSs also may be associated with higher leverage, greater levels of investment, and less-frequent strategic default. Importantly, all of these effects are related to the creditor rights, property rights, and market framework in which the underlying entity operates.

As noted above, this framework includes bankruptcy codes, contract enforcement, and corporate governance mechanisms. The existing empirical work provides evidence that U. The existence of CDS does not affect the cost of debt on average, but riskier firms experience an increase in spreads, while safer firms, as well as those firms with a priori high strategic default incentives, experience a decline in spreads see Ashcraft and Santos ; Kim Several papers present evidence that the credit risk of firms increases when CDS are introduced.

Narayanan and Uzmanoglu show that firm value declines as a result of increased costs of capital and lower credit quality when CDS are initiated. A smaller set of papers examine the effect of CDSs on investment. Chakraborty, Chava, and Ganduri find that firms with CDSs decrease investment after covenant violations.

Narayanan and Uzmanoglu present evidence that investment declines with CDS initiation. Danis and Gamba develop a model that shows that firms increase leverage and invest more after the introduction of CDSs. While the evidence to date indicates that CDS contracts have significant effects on the financial decisions of firms, the reference entities in almost all of these papers are headquartered in North America and, as a result, are subject to similar legal environments.

The results of our theoretical framework indicate that the effects of CDS introduction on leverage should be larger in countries with creditor-friendly bankruptcy codes, weaker contract enforceability, and higher concentration of shareholder ownership.

Consequently, in our empirical tests, we allow the impact of CDS introduction to differ with variation in the governance and legal environments in which the underlying reference entities operate. A single-name CDS contract specifies the underlying reference entity; the maturity of the contract; the ongoing payments that are required to be made by the protection buyer to the protection seller; the definition of the credit events that would trigger an obligation due from the protection seller to the protection buyer; the manner in which the payments from seller to buyer will be determined; and the manner in which the contractual securities may be delivered physically or otherwise will be set.

Three of these—bankruptcy, failure to pay, and restructuring—are principal credit events for corporate CDSs. When a trigger event occurs, CDS are settled through credit-default auctions, in which final recovery rates are determined through dealer bids, and the contract counterparties are settled accordingly either in cash or with the physical delivery of the underlying debt obligations.

Despite standard language, in the early days of CDS contracts there were significant disagreements and subsequent litigation over contract terms, including whether credit events had actually occurred, and thus whether obligations had been triggered.

Over the last 15 years, the ISDA has instituted changes in its Master Agreement in order to minimize ambiguity, create a more homogeneous CDS product, reduce counterparty risk, and streamline the processes through which settlement payments are determined. The most significant changes were included in the Big Bang Protocol in This protocol sets up regional Determination Committees DCs to consider whether a credit event has occurred, and to manage the auction process through which final CDS payments are settled.

In addition, restructuring was excluded as a credit event for North American reference entities although this was retained as a potential credit event in the rest of the world. While these changes have created a more standardized CDS contract, the legal environment in which a reference entity operates is still important.

Historically, Chapter 11 proceedings in the United States are the most common CDS credit event trigger in the world, but reference entities that operate outside the United States are subject to bankruptcy provisions that differ in the strength of their creditor protections, including the grants of automatic stays, prohibitions on debt payments, preservation of legal rights, and the length and timing of the resolution process.

For CDS contracts, these differences influence decisions regarding whether a credit event has occurred and could also influence the timing of settlement auctions in cases in which a credit event is deemed to have occurred.

In this case, local Spanish insolvency law and the global ISDA credit event definition provided conflicting interpretations of the nature of the underlying credit event. As these examples demonstrate, there can be significant legal issues to consider in the determination of contingent payoffs associated with CDS contracts.

In our formal model, we take into account this uncertainty about whether actions taken by the firm trigger payments due under the CDS contract. Our sample consists of all firms that have market data available on Datastream and accounting data available on WorldScope. We exclude financial firms, specifically, banks, insurance companies, real estate and other investment trusts, etc. We also exclude all firm-year observations that have zero or negative values for total assets.

Further, we exclude nonprimary issues, U. Our final sample consists of an unbalanced panel of more than 56, firms across 51 countries over the period — For these firms, we obtain monthly stock returns in U. Accounting variables are in millions of units of local currency and include determinants of CDS availability as well as general firm characteristics such as total assets, sales, profitability, leverage, and cash and short-term investments.

All firm-level variables are winsorized at the top and bottom five percentiles, with logical limits applied to mitigate the effect of data errors. Industry fixed effects are based on the Fama-French industry classification. Various legal, institutional, and financial market characteristics across countries are obtained from the data available from other existing studies La Porta et al.

Finally, all CDS data are obtained from Markit. Firms are identified as reference entities if they have CDS of any maturity during the observation year. Table D. We consider a setting that is an extension of a model proposed by Bolton and Oehmke We set the risk-free discount rate to zero to keep the notation simple, without loss of generality. During this out-of-court debt negotiation, either creditors can liquidate the firm e. As a specific example of this, consider a case in which the firm could credibly claim that an in-court restructuring filing is voluntary, rather than related to a credit event; this possibility would reduce the bargaining power of creditors.

In each state, the first term in the square brackets denotes the payoff to CDS creditors if they agree with the firm on debt restructuring, whereas the second term in the square brackets denotes their payoff if they reject the offer from the shareholders and take their case to the DC or, prior to the Big Bang, the local legal authority.

We provide below a description of the economic intuition behind these parameters and the variables in our data set that best capture these effects.

We then derive comparative statics for the sensitivity of the change in debt capacity due to the introduction of a CDS contract to changes in these parameters.

The parameters are as follows:. Debt renegotiation is costly when property rights are poorly enforced see, e. Poor contract enforcement lowers the recovery rate and also increases the time spent in repossessing collateral during the restructuring process. We use Closely Held Shares , the fraction of equity ownership held by controlling shareholders, obtained from Worldscope, as our proxy for concentration of shareholder ownership.

A creditor-friendly local bankruptcy code implies less uncertainty in the recognition of the CDS trigger event, and therefore, a greater expected CDS payout i. This aspect of creditor rights is captured by one of the components of the creditor rights index first introduced into the finance literature by La Porta et al.

The higher the liquidation value of the firm, or equivalently the lower the liquidation cost, the lower are the costs associated with the empty creditor problem. We use Secured Creditors First from Djankov et al. This creditor right establishes the priority of claimants specifically, creditors in payments resulting from liquidation of the firm. This is also consistent with the evidence in Djankov et al.

Proposition 1 presents the comparative statics of the model. Note that the first relation is novel to our framework, while the remaining three are related to parameters in Bolton and Oehmke and hence are implied by that model. Moreover, when creditors overinsure their debt positions through CDS contracts, liquidation becomes more likely than successful private renegotiation.

Under such circumstances, a higher liquidation value helps reduce the cost of debt capital that the firm must raise for its positive net present value investments. Based on the insights from the extended Bolton and Oehmke model presented above, we derive the following formal hypothesis: The introduction of CDSs will increase debt capacity more for firms in countries with less legal uncertainty around triggering events; low liquidation cost; weak contract enforceability; and more concentrated shareholder ownership.

The decision of whether to introduce CDSs to an individual firm headquartered in a particular country is endogenous and may be affected by characteristics of both the firm and the country. For instance, it may well be that CDS contracts are introduced on levered firms that are already distressed and are likely to face a higher probability of default. In addition, the introduction of such contracts may be affected by the stage of development of equity, debt, and derivatives markets; property rights; or bankruptcy codes in that country.

If such endogeneity is not taken into account, estimates of the effect of CDS introduction could be biased, since the firms that have CDS introduced on them i. Other studies have addressed this concern through the use of firm-specific instruments for CDS introduction.

However, in an international sample, the standard instrumental variable regression approaches widely used in U. We take endogeneity into account through our choice of empirical method. This method, propensity weighting, is relatively new and, to our knowledge, has not been used previously in the finance literature.

The intuition behind the method is fairly straightforward. We begin by estimating the probability that individual firms will experience a CDS introduction.

This step is similar to the method used for propensity-score matching. However, matching may reduce sample size, particularly in settings with multiple sets of characteristics to take into account e. Propensity weighting, in contrast, uses every observation in the sample with a positive probability of being included in both the treated and control groups.

Instead of matching, we use the estimated propensities to reweight observations in the sample in order to reduce differences in the characteristics of treated and nontreated firms. In effect, this method creates a synthetic sample for which the distribution of pretreatment variables, or covariates, is balanced across treated and nontreated firms. In this synthetic sample, there is no correlation between the treatment and the observed covariates.

In addition, the size of the synthetic sample is typically much larger than that in the matching analysis, which is a particular advantage in our case as the number of firms that have CDS introduced on them is small in comparison to the total number of firms in the sample. Note that this method weights each individual firm treated or nontreated by the probability that it will be assigned to the opposing group nontreated or treated, respectively.

Consider an individual firm that has a high estimated propensity for treatment and does, in fact, receive the treatment; this type of firm is relatively common, as it has covariate values that are comparable to those of other treated firms. Such a firm will be down-weighted to account for the commonness of its observation.

In contrast, a treated firm with a low predicted probability of being treated will receive a higher weight. As a result, individual firms with a low high predicted probability of treatment that actually receive the treatment will be up- down- weighted; the up-weighting allows the low-propensity treated firm to represent a larger group of similar firms that did not receive the treatment.

Similarly, for nontreated firms, those with a high low probability of treatment will be up- down- weighted. This weighting of observations yields a synthetic sample of treated and nontreated firms with balanced covariates by construction. The method proposed by Li, Morgan, and Zaslavsky is related to inverse probability weighting, as described by Hirano and Imbens As the name suggests, inverse probability weighting uses the reciprocal of the estimated propensity for treatment to weight observations in the sample.

However, inverse probability weighting has the drawback that when estimated probabilities are very small, weights can become extremely large and the resultant estimates become unstable.

In contrast, the overlap weights proposed by Li, Morgan, and Zaslavsky , which we use in this paper, are bounded between 0 and 1, do not require truncation, result in exact balance of the covariates, and, for plausible distributions of propensity weights, are associated with smaller standard errors in the estimates of treatment effects. Intuitively, the overlap weighting method results in a synthetic sample that can be interpreted as the set of firms that have a substantial probability both of having CDS introduced and of not having CDS contracts available.

We estimate the effects of CDS introduction on this propensity-weighted sample. In Section 6. These tests include a simulation-based analysis of the sensitivity of our main results to potential omitted variable biases Ichino, Mealli, and Nannicini , and the use of additional controls in the propensity-weighting method.

We also confirm the key conditional independence of our treatment assignment using alternative OLS estimations. Table 1 reports the summary statistics of the sample by country and by industry.

In panel A, we report the number of firms with available CDS by country and by year. Each year, on average, 1, firms have available CDSs. Note, however, that developed countries differ significantly with regards to the country characteristics we consider. For example, the G7 countries span the entire spectrum of creditor rights, as defined in Djankov et al. CDS introductions were relatively numerous prior to the financial crisis, with the number of introductions declining sharply after Importantly, note that the majority of CDS firms and introductions in our sample are in countries other than the United States, which has been the focus of prior CDS studies.

The table shows the number of CDS reference entities by year across countries panel A and industries panel C and the number of CDS introductions by year across countries panel B.

Countries in panels A and B are sorted by the creditor rights index as reported in the last column of panel A. The sample consists of an unbalanced panel of more than 56, nonfinancial firms across 51 countries over the period — Table 1 , panel C, reports the number of firms in each industry that have CDS available by year, using the Fama-French industry groupings.

We see significant variation in the patterns of CDS availability across industries. The variation in CDS availability across sectors, observed in panel C of Table 1 , suggests that there are systematic differences between firms on which CDS have been introduced.

In addition, the evidence reported in panels A and B of Table 1 suggests that differences in country characteristics may also influence CDS introduction. We therefore estimate the propensity of CDS introduction allowing for both firm- and country-specific characteristics.

To measure the concentration of equity ownership, we use the percentage of closely held shares Closely Held Shares , defined as the percentage of shares held by insiders.

Country characteristics include four categories of the local legal and financial environment: creditor rights, property rights, the availability of private credit, and financial market sophistication. To measure the strength of creditor rights, we use variables constructed by Djankov et al. Each of the creditor rights characteristics Restrictions on Entry , No Automatic Stay, Management Does Not Stay, and Secured Creditors First is measured as an indicator variable, with a value of one indicating stronger creditor rights.

For each of these indexes, higher scores indicate better ratings i. We estimate logit regressions in which the dependent variable is equal to one if CDS are introduced on an individual firm in a particular year, and zero otherwise. Standard errors are clustered at the firm level.

All explanatory variables are lagged by one year to allow for errors in the measurement of the date of introduction of CDS trading. We standardize ownership concentration and country variables for comparability.

Table 2 reports results from the logit regressions; for expositional purposes, we report coefficients from regressions with single regressors. Coefficients on the aggregate Creditor Rights index, as well as three of the four components of Creditor Rights , are negative and statistically significant. These results indicate that CDS are less more likely to be introduced on firms that operate in countries with strong weak creditor rights.

The exception to this is the case in which secured creditors receive priority in payments from the proceeds of liquidation Secured Creditor First.

For that variable, the coefficient is statistically significant and positive, indicating that CDS introductions are more likely in environments that feature priority protection for creditors in the event of liquidation. The table shows the results of logit regressions in which the CDS introduction dummy i. Firm characteristics and country characteristics serve as explanatory variables, and all are lagged by one year.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Investors should consult their investment professional prior to making an investment decision. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. PIMCO provides services only to qualified institutions and investors.

This is not an offer to any person in any jurisdiction where unlawful or unauthorized. The services and products provided by Pimco Europe GmbH are available only to professional clients as defined in Section 31a para.

They are not available to individual investors, who should not rely on this communication. The services and products provided by PIMCO Schweiz GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised.

This communication is provided for general information only without taking into account the objectives, financial situation or needs of any particular investors.

Box , Toronto, ON, M5L 1G2 services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.

Saved Content And Share Content.