Will the Use of Credit Default Swaps Affect Firm Risk and Value? Evidence from U.S. Life and...

Will the Use of Credit Default Swaps Affect Firm Risk and Value?

Evidence from U.S. Life and Property/Casualty Insurance Companies

Hung-Gay FungCollege of Business Administration

University of Missouri-St. LouisMin-Ming Wen

College of Business and EconomicsCalifornia State University, Los Angeles

Gaiyan Zhang College of Business Administration

University of Missouri-St. Louis

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2010 Taiwan Conferences -Fung, Wen & Zhang

Motivation• Financial Crisis in 2008• AIG was on the edge of falling apart

the (ab)use of CDS?• Insurance companies have been among the most active

market participants in the credit derivatives market– According to British Bankers’ Association (2006),

insurers worldwide held an 18% market share for selling CDS protection; 6% of the CDS market for buying credit protection.

• This study examines the use of CDS in the pre-crisis period. (from 2001-2007)

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CDS trading motives

• Why do insurers sell CDS? – income generation (for taking credit risks)– replication (similar to bond holdings for receiving

fixed payment by taking credit risks; but with a more flexible choice in maturity)

– speculation (simply for transaction purpose)• Why do insurers buy CDS?

– hedging (managing credit risks embedded in bond portfolios)

– speculation (simply for transaction purpose)

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CDS and Risk: Literature Review

• Existing studies on CDS usage have primarily focused on risk-hedging and/or risk-taking behaviors by banks and hedge funds.

• Credit derivatives use by banks (Minton, Stulz and Williamson (2009), Shao (2010))

Shao (2009) finds an increase in the risk profiles for bank protection sellers but no evidence that bank protection buyers have higher risk.

Instefjord (2005) risk-sharing benefits from credit derivatives may encourage banks to take more risk

Morrison (2005) finds that credit derivatives can reduce banks’ incentives to monitor their loan portfolios.

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CDS and Risk

• Credit derivatives use by hedge funds (Chen, 2010) the use of credit derivatives decreases total risk for hedge funds.

• Derivative use by insurers (Colquitt and Hoyt 1997; Cummins, Phillips, and Smith 1997, 2001). not CDS specifically!

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Research Questions

• CDS Buy position reduces credit risk if it is for hedging purpose can this be transferred to risk-reduction as a whole?

• CDS Buy position carries investment risk if it is for transaction purpose how does it affect firm’s risks?

• CDS sell position increases credit risk if it is for income generation purpose how does it affect firm’s risks?

• CDS sell position reduce asset-liability duration risk can it be transferred to the reduction of firm’s risks?

How does the use of CDS affect firm risks? How are the effects of CDS use on firm risks

transferred to the effects on firm value?

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Research Design

• CDS use

Buyers v.s. sellers

• Risk Measures

total risk, market risk, and idiosyncratic risk

• Firm value measure

Tobin’s Q (market-based measure), ROA (accounting-based measure)

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Main Findings: CDS & Risk

CDS-Participation Total risk Systematic Risk Idiosyncratic risk

Life + + +

PC + + +

CDS Positions Total risk Systematic Risk Idiosyncratic risk

Life – Net Sellers + + +

Life – Net Buyers +

PC – Net Sellers + +

PC – Net Buyers + + +

risk-increasing trading dominates risk-decreasing trading

risk increasing trading is associated with income generation &

speculation purposes

risk-decreasing trading: hedging and replication.

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Main Findings: CDS & Firm Value

CDS-Participation Tobin’s Q:

MV/BV (assets)

MV/BV (equity) ROA

Life - - -

PC - - -

CDS Net Sell/Net

Buy Positions

Tobin’s Q:

MV/BV (assets)

MV/BV (equity) ROA

Life – Net Sellers NS NS NS

Life – Net Buyers - - -

PC – Net Sellers - - -

PC – Net Buyers - - -

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Data• Data sources: the merge of NAIC derivative data,

CompuStat and CRSP. – Data uniqueness: the detailed nature of the data on credit

derivatives use reported by insurance companies to NAIC

• Our focus: the behaviors of 44 distinct insurers who participate in the CDS market and have CompuStat and CRSP data available.– 33 Life insurers and 11 PC insurers.

– firm-year observations are 427 (Life) and 666 (PC).

– the total number of transaction observations: 4,889 (Life) and 1,639 (PC)

– CDS non-users: 212 publicly-listed insurers including 85 (Life) 127 (PC).

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Methodology and Empirical Results • Simultaneous Equation Model on Risk Analysis: potential

endogeneity between risk and derivative use (Graham and Rogers, 2002)

Riski,t= α1 + β1,1 ×CDSi,t + tii Z ,,1 + β1,2 ×Div_yieldi + β1,3 ×CDS_Changei,t +

β1,4 ×Spread_Volti,t + ε1,i,t (3)

CDSi,= α2 + β2,1 ×Riski,t + tii Z ,,2 + β2,2 ×NY_Dummyi,t + β2,3 ×CDS_Changei,t +

β2,4 ×Spread_Volti,t +ε2,i,t , (4)

Risk Variable: total risk, systematic risk, and idiosyncratic risk. CDS Variable: CDS_Dummyi,t = one if insurer i participates in CDS transactions Net_Buyeri,t = one if the aggregate notional amount of the CDS buy

position is greater than that of the sell position; Net_Selleri,t = one if the aggregate notional amount of the CDS sell

position is greater than that of the buy position.

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Table 1. Summary of CDS Transactions for Life and PC Insurers

• 2010Taiwan_Presentation_Tables.doc

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Table 2. Descriptive Statistics for the Entire Sample (CDS_users & Non_CDS Users)

• Table 2 presents the descriptive statistics of risk, firm value, and other control variables used in the analysis.

• Panels A and B are for the samples of Life and PC insurers, respectively.


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Table 3.

• Table 3 compares medians and means of risk, firm value, and other firm characteristic variables between insurers – CDS users, CDS net buyers, CDS net sellers – and those non-CDS users.

• 2010Taiwan_Presentation_Tables.doc• Life insurers with CDS transactions: have a larger

systematic risk, lower idiosyncratic risk, and lower total risk than those of non-CDS users.

• Both net buyers and net sellers have significantly higher systematic risk, lower idiosyncratic risk, and lower total risk than non-CDS users.

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Table 3

• Life Insurers: non-CDS users have larger Tobin’s Q, market-to-book value of equity, and return on asset than CDS users, net buyers, net sellers.

• PC Insurers: – No significant difference in total risk between CDS users and non-users.– CDS users have higher systematic risk and lower idiosyncratic risk than

those of non-CDS users. – Net buyers have significantly higher systematic risk and lower idiosyncratic

risk than non-CDS users. – No significant difference in total risk between net buyers and non-users.– Net sellers show significantly higher market risk and higher idiosyncratic

risk than non-users, – No significant difference in total risk between net sellers and non-users.

• CDS users have lower Tobin’s Q, lower market-to-book equity value, and lower ROA than non-users.

• CDS net buyers and net sellers also have lower Tobin’s Q, market-to-book equity value, and ROA than non-users.

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Summary of Univariate Analysis

• Life and PC CDS users (regardless of their positions as net buyers or net sellers) have higher market risk than non-users

a positive relation between the market risk of insurers and their participation in the CDS market.

• Second, Life CDS users have lower idiosyncratic risk and total risk than non-users.

• Finally, Life and PC CDS users have lower firm values.

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Table 4. Risk Models

CDS-Participation Total risk Systematic Risk Idiosyncratic risk

Life + + +

PC + + +

CDS Positions Total risk Systematic Risk Idiosyncratic risk

Life – Net Sellers + + +

Life – Net Buyers +

PC – Net Sellers + +

PC – Net Buyers + + +

risk-increasing trading dominates risk-decreasing trading

risk increasing trading is associated with income generation &

speculation purposes

risk-decreasing trading: hedging and replication.

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Table 4. Risk Models• 2010Taiwan_Presentation_Tables.doc• Panel A1: (risk equation, Life insurers): participation in CDS

transactions significantly increases total risk; Net sellers dummy variable significantly increase total risk writing CDS contracts increases Life insurers’ total risk. buying CDS protection has insignificant effects on Life insurers’ total risk.

• In the CDS equation: CDS use and participation positions are positively and significantly related to total risk. those insurers with higher total risk are more likely to engage in CDS transactions, both as net sellers and as net buyers, holding other things constant.

• Panel B1 (PC insurers) are quite similar to those for Life insurer sample;

• both net buyers and net sellers have significantly higher total risk.

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Table 5: Regression Model on Firm Performance

Performance= α0 + βj ×CDSi,t + tii Z , + εi,t (5)

Proxy for firm value/performance measure:

Tobin’s Q, ratio of market value of equity to book-value equity,

Tobin’s Q is defined as the market value of equity plus the book value of liabilities

divided by the book value of assets,

i.e.,)(

)()()(

assetstotalBV

equitycommonMVequitycommonBVassetstotalBVTQ

,

where MV (common equity) is the product of stock price and number shares

outstanding;

MV(Eqty)/BV(Eqty) )(

)()(_)(

equitycommonBV

equitycommonMVEqtyBVEqtyMV ;

ROA is return on book value asset.

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CDS-Participation Tobin’s Q:

MV/BV (assets)

MV/BV (equity) ROA

Life - - -

PC - - -

CDS Net Sell/Net

Buy Positions

Tobin’s Q:

MV/BV (assets)

MV/BV (equity) ROA

Life – Net Sellers NS NS NS

Life – Net Buyers - - -

PC – Net Sellers - - -

PC – Net Buyers - - -

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Contributions• We extend a series of studies on derivative usage by insurance

companies by focusing on credit derivatives, credit default swaps on particular

• Our paper complements the study on bank and hedge fund use of credit derivatives– Shed light on the opaque and largely unregulated CDS market

• This study shows: – CDS utilization alters the risk profile of both Life and PC insurers by

increasing each dimension of risk.

– CDS utilization deteriorates the financial performance.

• Our findings support the effort of the NAIC working with the insurance regulators to monitor more closely how insurance

companies engage in derivative transactions.

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Will the Use of Credit Default Swaps Affect Firm Risk and Value? Evidence from U.S. Life and...

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