Essays on the Impact of Credit Default Swaps on Corporate Debt

A credit default swap (CDS) is a derivative contract based on an underlying entitity's debt, in which, a seller compensates the buyer for losses to the value of the underlying asset due to a credit event. CDS can be purchased covered along with the underlying asset or naked without any exposure to the underlying asset. Thus they can be used for both hedging and speculating on credit risk. In this dissertation I study the role of CDS in corporate debt markets in presence of asymmetric information in a general equilibrium production economy with heterogeneous firms and agents. I find that CDS can amplify or weaken the asymmetric information friction in credit markets and thus can be used to help overcome the asymmetric information problem. When credit markets cannot distinguish between firm types, firms use debt issuance as a signaling mechanism to inform market participants of their type. In Covered CDS economies,firms respond by rationing issuance to signal their type. In Naked CDS economies, the signaling mechanism can entail rationing or expansion depending on the productivity of firms with CDS exposure. Consequently, I find that CDS exposure can lead to higher profits despite increasing firm borrowing costs. This novel result suggests that within the context of the CDS literature, borrowing cost can be an inadequate indicator for firm performance. Introduction of credit derivatives can alter the set of agents pricing debt instruments which leads to reallocation of capital away from underlying debt markets into derivatives markets thus having borrowing cost implications for reference and non-reference entities. Covered CDS Economies experience lower borrowing costs for all firms even when CDS contracts are traded on only one firm type. This leads to higher investment levels in the economy, but raises the likelihood of default when productivity shocks are bad. Introducing Naked CDS raise borrowing costs for all firms even when CDS contracts trade on a single firm type. This lowers investment levels in the economy, and lowers the likelihood of default. General equilibrium models of firm financing with CDS suggest that collateralized CDS contracts may reallocate capital away from bond markets and into derivative markets. We find evidence, conditional on firm rating, that the introduction of CDS affects the cost of issuing bonds for firms who are not single-named CDS reference entities. Borrowing costs for investment-grade firms increase, whereas borrowing costs for high-yield firms decrease when CDS are introduced for equivalently rated firms. We attribute the difference in borrowing costs across ratings classes due to differences in how CDS affect the liquidity of investment-grade versus high-yield corporate bonds. Various robustness checks are conducted for the endogeneity of both CDS introduction and bond issuance.