HOW CREDIT DEFAULT SWAPS AFFECT RISK-SHIFTING

We study the effects of credit default swaps (CDSs) on a firm's risk-shifting behavior. Because CDSs provide debtholders (or banks) with protection against credit events, CDS-protected debtholders may not be as vigilant in monitoring borrowers once their credit risks are hedged. In addition, CDSs strengthen debtholders' negotiating power and potentially increase default rates, which strengthens borrowers' incentives for risk-shifting. Therefore, managers of CDS-referenced firms are encouraged to expropriate debtholder wealth by shifting to riskier investments. We find significant empirical evidence that the initiation of CDS trading increases risk-shifting behavior. Moreover, the effects of CDSs on risk-shifting are more pronounced for financially distressed firms. Our results are robust to a falsification test, a reverse causality test, and a test of selection bias.