THE INCEPTION OF CREDIT DEFAULT SWAP TRADING AND CORPORATE COST STRUCTURE

Abstract

Prior literature shows that how creditors monitor borrowers and exercise control rights affect borrowers’ investment and financial policies, but little is known about their impact on borrowers’ operating decisions. The availability of a credit default swap (CDS) reduces creditors’ monitoring incentives ex ante but increases their liquidation incentives in the events of default ex post. After the inception of CDS trading, reference firms exhibit an increase in the elasticity of cost structure. Results are consistent in instrumental variable analyses and are robust with alternative matching samples. The increase in cost structure elasticity is more pronounced for firms with greater credit risk and more restrictive covenants, financially constrained firms, and those face greater product market competition and provide higher convexity in managers’ compensation. We provide the first evidence showing that managers choose a more elastic cost structure when creditors become less forgiving.