Abstract

We document that credit default swaps (CDS) trading on a firm’s debt positively influences its technological innovation measured using patents and patent citations. The positive effect is more pronounced for firms relying more on debt financing, borrowing from banks, borrowing from fewer bank lenders, having more restrictive debt covenants, or using more short-term debt prior to CDS introduction. Further analysis shows that firms’ innovation strategies become more risky and long-term oriented after the advent of CDS trading. These results suggest that CDS foster borrowing firms’ innovation via enhancing lenders’ risk tolerance and borrowers’ risk taking in the innovation process. Taken together, our findings reveal the real effects of financial innovation (i.e., CDS ) on companies’ investment and technological progress.