The Leverage Externalities of Credit Default Swaps

This paper provides the first empirical evidence of the externalities of credit default swaps (CDS). We find that a firm's leverage is lower when a larger proportion of its revenue derives from customers referenced by CDS. This finding is robust to alternative samples and measures, placebo tests, and the selection of customers by suppliers. Moreover, firms affected by customer CDS trading increase equity issuance and reduce investment, which is consistent with the view that CDS trading on customers improves the information environment for suppliers and provides information about customer default risk. Therefore, while many firms are not directly linked to CDS trading, CDS trading on their customers has spillover effects on these firms' financial policies