Credit Default Swaps in General Equilibrium: Endogenous Default and Credit Spread Spillovers

Abstract

This paper shows that credit default swaps (CDS) can affect the type of debt firms issue. Firms face a trade-off between investment scale and the cost of capital measured by the credit spread. Small-scale investment is safe, fully collateralized, but earns modest profits in all states. Large-scale investment is risky, requires a positive credit spread, but yields high profits only in good states and default in bad states. CDS only affect risky credit spreads, which in turn affects the opportunity cost of issuing collateralized, safe debt. Covered (Naked) CDS lower (raise) credit spreads and raise (lower) the likelihood of issuing risky debt. Lastly, we show that CDS generate credit spread and investment spillovers for non CDS-referenced firms.