Credit default swaps and corporate performance smoothing

Credit Default Swaps and Earnings Management

Market conditions, default risk and credit spreads

Subject. The article investigates the volatility of deposit cash flow. The presented study reveals the relationship between the actions of actors with different types of behavior and the volatility of deposit cash flow. Objectives. The aim is to develop an approach to identify volatility caused by behavioral reactions of economic actors. Methods. The study employs a methodological approach to the analysis of the volatility of cash flows, which involves fractal and regression analyses, the construction of Shewhart charts. The latter enabled to determine turbulent values of the deposit cash flow. Results. The volatility of deposit cash flows depends on institutional and behavioral factors. Based on fractal analysis, we determined preservation of structural conditions for deposit cash flow for 32 months. Simultaneous panic actions of actors lead to the formation of a turbulent deposit cash flow, creating shocks for the banking system. It is empirically estimated that an increase in the key rate by 1% leads to an increase in the probability of a turbulent cash flow by 1.9%. Any improvement in the news background reduces the probability of turbulent deposit cash flow. The greatest impact on the likelihood of a turbulent cash flow has a news background with a lag of two months. Conclusions. Regulation of the volatility of cash flows is advisable in a situation of panic actions on the part of economic actors. The Bank of Russia, through applying the data of the Bank of Russia Payment System, can contribute to the implementation of the policy of regulating the volatility of cash flows caused by behavioral reactions of economic actors.

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank. CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price. Regulation is found to induce the risk-neutral bank to behave in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases. CDS trading is found to interact with the former effect when regulation accepts CDS as an instrument to mitigate credit risk. Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased. However, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased. This promotes the intention of the Basel II (and III) regulations to “strengthen the soundness and stability of banks”.

We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank . CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price . Regulation is found to induce the risk-neutral bank to behav e in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases . CDS trading is found to interact with the former ef fect when regulation accepts CDS as an instrument to mitigate credit risk . Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased . Howev er, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased . This promotes the intention of the Basel II (and III) r egulations to “strengthen the soundness and stability of banks” . * Paper presented at the 2012 conferences of the European Financial Management Association (EFMA) in Barcelona and the Verein fur Socialpolitik in Gottingen, at the 2011 conference of the German Economic Association of Business Administration (GEABA) in Zurich, at the Financial Risks International Forum 2012 in Paris, at the 2011 workshop of the Research Task Force of the Basel Committee on Banking Supervision in Istanbul, and at the Bundesbank Research Seminar in Frankfurt . We w ould like to thank conference, workshop and seminar participants and in particular Ulrich Krueger, Peter Raupach, Thomas Gehrig, Bent Vale and Nikolaos Papanikolaou for valuable comments and suggestions . The views expr essed in this paper represent the authors’ personal opinions and do not neces

Credit default swaps (CDS) are derivative contracts that are widely used as tools for credit risk management. However, in recent years, concerns have been raised about whether CDS trading itself affects the credit risk of the reference entities. We use a unique, comprehensive sample covering CDS trading of 901 North American corporate issuers, between June 1997 and April 2009, to address this question. We find that the probability of both a credit rating downgrade and bankruptcy increase, with large economic magnitudes, after the inception of CDS trading. This finding is robust to controlling for the endogeneity of CDS trading. Beyond the CDS introduction effect, we show that firms with relatively larger amounts of CDS contracts outstanding, and those with relatively more no restructuring contracts than other types of CDS contracts covering restructuring, are more adversely affected by CDS trading. Moreover, the number of creditors increases after CDS trading begins, exacerbating creditor coordination failure for the resolution of financial distress.

Does the Tail Wag the Dog? The Effect of Credit Default Swaps on Credit Risk

Credit Default Swaps and Lender Moral Hazard

This study develops a difference‐in‐differences analysis to assess whether trading onset of credit default swaps (CDS) on a firm's debt improves price informativeness in the stock market. Price informativeness is measured by the future earnings response coefficient, which captures the amount of information about future earnings conveyed in stock returns. Our sample comprises U.S. firms (firms experiencing CDS trading on their debt and a group of control firms) and covers the period 1997–2015. The results indicate that CDS hinder stock price informativeness, and thus the ability of prices to track long‐term fundamentals, especially before the arrival of negative information about the obligor. The identified impact is stronger when CDS are first traded, becoming less pervasive with the passage of time. Finally, the results indicate that effects were residual during the early stages of CDS market development and peaked during the period 2004–2008. The impact of CDS introduction weakened after new regulation and ISDA protocols entry into force in 2009. This empirical analysis contributes to the literature by improving knowledge on the consequences of CDS trading on economic and financial outcomes. It points out a negative effect on price informativeness in the stock market and indicates that it was smoothed by regulatory measures designed to improve market infrastructure and transparency.

Liquidity and Credit Default Swap Spreads

This dissertation consists of three chapters. The first chapter examines whether the availability of credit default swaps (CDS) has consequences for creditor governance. CDSs offer creditors the opportunity to hedge credit risk and may impact their willingness to renegotiate debt agreements after covenant violations and to monitor firms. I show that firms implement more conservative investment and financing policies after covenant violations if CDSs are traded on their debt, consistent with heightened renegotiation frictions. Moreover, firms with traded CDS contracts exhibit significantly worse operating and stock performance after covenant violations. Overall, these findings point to an exacerbation of debt-equity conflicts due to the availability of CDSs. Finally, I analyze the interaction of creditor governance and internal governance, and provide evidence suggesting that the possibility to hedge risk through CDSs also reduces creditors'€™ incentives to monitor firms. The second chapter models the joint effects of debt, macroeconomic conditions, and cash flow cyclicality on risk-shifting behavior and managerial pay-for-performance sensitivity. I show that risk-shifting incentives rise during recessions and that the shareholders can eliminate such adverse incentives by reducing the equity-based compensation in managerial contracts. I also show that this reduction should be larger in highly procyclical firms. Using a sample of U.S. public firms, I provide evidence supportive of the model'€™s prediction. First, I find that equity-based incentives are reduced during recessions. Second, I show that the magnitude of this effect is increasing in a firm's cash flow cyclicality. The third chapter analyzes the impact of the formation of universal banks on corporate investment by looking at the gradual dismantling of the Glass-Steagall Act'€™s separation between commercial and investment banking. Using a matched sample of U.S. firms and their relationship banks, I show that firms curtail investment after positive shocks to the underwriting capacity of their main bank. This result is driven by unrated firms and is strongest in the first two years after a shock. Moreover, I obtain similar results for borrowing firms'€™ net debt issuance activity. As an exogenous shock to the formation of universal banks in the U.S., I also use the 1997 loosening of restrictions on commercial banks'€™ securities activities. My findings suggest that universal banks may pay more attention to large and transparent firms that provide more underwriting opportunities while exacerbating financial constraints of opaque firms.

The Effect of Credit Default Swaps on Risk Shifting

Does the Onset of CDS Trading Increase Tax Avoidance?

How Does Web Personalization Create Value for Online Retailers? Lower Cash Flow Volatility or Enhanced Cash Flows

This study investigates the relationship between cash flow volatility and leverage in Jordanian firms. The research purpose is to investigate whether cash flow volatility affects a company’s capital structure in Jordan. Panel data analysis is used in this study for a sample of 72 shareholder non-financial companies in Jordan from 2009 to 2020. The findings show that cash flow volatility has a significant link with leverage, indicating that companies with higher cash flow volatility tend to use more debt financing. In addition, the study finds that firm size, return on assets, and tangibility are positively associated with leverage, while growth is not significantly related. The study suggests that firms in Jordan should take cash flow volatility in consideration when making capital structure decisions. The study provides evidence that cash flow volatility is a vital determinant of leverage in Jordanian companies. The findings suggest that managers should consider the cash flow volatility effect on the capital structure alternatives of their firms. AcknowledgmentI want to thank Amman Arab University for its support.