Credit risk and the consequences for corporate policies 

A new research project led by Professor Alberto Plazzi, director of the Master in Finance at USI Faculty of Economics, has received positive feedback from the Swiss National Science Foundation (SNSF). The study "The Determinants and Corporate Implications of Credit Derivatives: Evidence from the CDS Market" aims to deepen the understanding of the factors that determine the so-called pricing and trading of credit risk and its consequences on corporate policies and behaviour.

Professor Plazzi, what are credit default swap (CDS) contracts?

Credit default swaps (CDS) are credit derivatives, namely financial contracts whose payments to the parties involved rely on the creditworthiness of a reference entity unrelated to the contract itself. The credit event that triggers the payments in CDS is the default of a company or government, defined either as bankruptcy in the strict sense or as a change in contractual terms such that it creates a loss of value for bondholders. In CDSs, one counterparty (seller) pays an amount to the other counterparty (buyer) if the reference entity defaults.

In this way, the buyers purchase insurance that "compensates" them for any loss that the default may have caused them, for example, if they were the creditors (e.g., bondholders) of the entity itself. In exchange for this insurance, the buyers periodically pay the seller a premium set on the date of stipulation and naturally based on the perception as to whether the entity will default over the term of the contract (usually five years). The premium is expressed as a percentage of a notional capital. For this reason, CDS premiums provide a real-time assessment of an entity credit conditions. CDS are the most popular credit derivatives, as they allow financial institutions such as banks to reduce their credit risk by transferring it to other entities.

What do your projects consist of, and how are they structured?

The three projects aim to use data on CDS available for many firms on a daily basis. The first project aims at comparing CDSs for which the reference entity is listed with those written on unlisted companies in order to identify whether there is a systematic spread and what the determinants are. In contrast, the second project seeks to investigate whether the introduction of CDSs on a reference entity changes the inclination of shareholders to become more active in monitoring the management. Indeed, it is conceivable that the introduction of CDSs would reduce the bondholders incentive to monitor the company's management, as they are now protected by default and no longer bear losses. Finally, the third project aims to analyse how the COVID pandemic has changed the relationship between the credit risk (as measured by CDS) of companies and that of the sovereign state in which they are incorporated with a focus on the Eurozone.

What are the objectives of this study?

As pointed out earlier, CDSs reflect a timely financial market assessment of an entity's creditworthiness. As such, CDS premiums are also a component of the cost of capital. That is, if the annual premium on a company in a 5-year CDS contract is 2 per cent, this suggests that the interest rate in a loan of equal duration to that company should be increased by (at least) 2 per cent to compensate for the credit risk assumed at stipulation.

The first study, as mentioned, is concerned with differences in the premium between listed and private firms. This analysis can have significant implications regarding a company's decision to go public through an IPO, an Initial Public Offering, as it gives insight into the effect of listing on the cost of capital.

The second study aims to identify the potential effects of the introduction of CDS in the "monitoring" activity of shareholders. The primary point is that the possibility for creditors/bondholders to reduce their liability exposure to a company by subscribing to a CDS may cause them to monitor the company's management less efficiently. This, conversely, implies that shareholders should be more involved in it. The results of this study would be interesting from a governance perspective to understand how investor activism relates to their exposure.

The last point wants to use the shock from the Covid pandemic to establish a relationship between corporate and sovereign credit risk and the latter's fiscal capacity. The goal is to quantify how a country's "fiscal space" can benefit the companies incorporated in it (i.e., decrease their CDS) through investors' expectation that, in the event of a shock, the government can intervene with supportive manoeuvres. This study has implications for the link between a public debt sustainability and firms’ cost of capital.