- All Best Essays, Term Papers and Book Report

The Reaction of Credit Default Swap Prices to Corporate Dividend Reductions

Essay by   •  March 18, 2012  •  Research Paper  •  4,703 Words (19 Pages)  •  1,448 Views

Essay Preview: The Reaction of Credit Default Swap Prices to Corporate Dividend Reductions

Report this essay
Page 1 of 19

Matthew Palmgren, Hunthill Capital, LLC

Harold B. Tamule, Providence College


Our paper explores the reaction of a credit default swap to a material corporate even, i.e.

the announcement of a planned reduction in a corporate dividend payment. The first

section, CDS Features, defines what credit default swaps are, who uses them, and how

they work. The second section, Recent Events in the CDS Market, describes the recent

history of this financial contract. The third section of this study focuses on changes in

corporate dividend policy, and their effect on firms' outstanding CDS prices . Last is an

event study to show empirically what happens to the cost of insuring a firm's debt at

different maturities before and after a dividend cut. This study shows empirically

whether or not the CDS market leads or lags the announcement of a dividend cut. Since

the rapidity of the movement will be monitored, our research is also a test of the efficient

market hypothesis.


With domestic financial markets recently in turmoil and disarray, some blame complex financial

derivatives such as credit default swaps (Land, 2008). Some financial firms that have had large exposure

to these over-the-counter (OTC) derivatives have experienced severe adverse price movement and

financial distress. Investors, firms, and regulators have struggled to prevent these derivatives from further

hurting the broader economy. What started as a seemingly straight-forward way to reduce risk or increase

cash flow has become an instrument of danger to modern corporate finance (Duffie, 2008; Dickinson,


A credit default swap (CDS) is a derivative contract whose value negatively depends on that of an

underlying bond or loan. The buyer of the CDS makes a series of interest payments to the seller and

upon a contractually defined credit event, i.e., a default, the seller swaps to the buyer a payment to make

them whole. A credit event may include bankruptcy, failure to make a principal payment or an obligation

default. An investor does not even need to own a bond in order to purchase a credit default swap on it

(Houweling and Vorst, 2005). Therefore a CDS is a hedge against any possible losses due to uncertain

defaults. A CDS can also transfer risk to a third party, much like securitization transfers risk. By

providing such useful features the CDS market has grown rapidly and almost doubled every year from

2001 to 2007, with notional outstanding value of $54.6 trillion by the second quarter of 2008. By

comparison this aggregate CDS principal was larger than both the world GDP and the value of all the

stocks on the New York Stock Exchange at the time (Varchaver and Benner, 2008). Credit research from

HSBC's European Credit Strategy estimates that as of November 7, 2008 the largest net CDS exposures

are on sovereignties. Italy, Spain, and Brazil hold the greatest exposure, netting a combined $42.9 billion

outstanding. Financial firms have the next greatest exposures, with GE Capital, Deutsche Bank, and

Morgan Stanley netting $28.2 Billion combined.

One major shortcoming of the CDS market is its natural lack of transparency and liquidity since

these contracts are not sold by broker-dealers who are participant-members of continuous auction

exchanges. Rather, they are sold at a dealer's discretion in unorganized market-making activity. Thus no

public trade information on prices of CDS contracts and intraday prices are directly available to investors,

or CDS data are available only through certain secure databases. Therefore, the opportunity of general

investors to react to the pricing of these securities is severely limited. While transparency in the market

may evolve with exchange trading, however, the elimination of OTC trading would prevent the

customization of these contracts (Dickinson, 2009). Since existing CDS contracts may contain unique

definitions as what defines a credit event, they would be impossible to trade on an exchange that requires

standardized contracts and a continuous auction format.

Dickinson speculates that a debt decoupling attribute of a CDS helps create systemic risk in the

financial sector, an unintended consequence that puts the entire financial system at risk. This splitting

separates the economic interest of a firm's creditors from their control rights and creates systemic risk

from moral hazard and negative economic interest. Most apparent in the banking industry, the CDS

market decreases the value of banker's due diligence for their corporate clients when the cost of the CDS,

i.e. the premium, is less than the cost to perform due diligence, i.e. credit analysis on the borrower.

Collateral requirements may become the only true gauge on a firm's repayment ability. This creates an

adverse situation for other stakeholders in the credited firm, since this repayment ability may be a

pretense. More speculative banking practices and all around poorer investments



Download as:   txt (31.4 Kb)   pdf (300.3 Kb)   docx (26.5 Kb)  
Continue for 18 more pages »
Only available on
Citation Generator

(2012, 03). The Reaction of Credit Default Swap Prices to Corporate Dividend Reductions. Retrieved 03, 2012, from

"The Reaction of Credit Default Swap Prices to Corporate Dividend Reductions" 03 2012. 2012. 03 2012 <>.

"The Reaction of Credit Default Swap Prices to Corporate Dividend Reductions.", 03 2012. Web. 03 2012. <>.

"The Reaction of Credit Default Swap Prices to Corporate Dividend Reductions." 03, 2012. Accessed 03, 2012.