The Impact of Earnings on the Pricing of Credit Default Swaps

Abstract (Via U Toronto)

This study evaluates the impact of earnings on credit risk in the Credit Default Swap (CDS) market using levels, changes, and event study analyses. We find that earnings (cash flows, accruals) of reference firms are negatively and significantly correlated with the level of CDS premia, consistent with earnings (cash flows, accruals) conveying information about default risk. Based on the changes analysis, a 1 percent increase in ROA decreases CDS rates significantly by about 5 percent. We also find that (1) CDS premia are more highly correlated with below-median earnings than with above-median earnings and (2) CDS premia are more highly correlated with earnings of low-rated firms than with earnings of high-rated firms. Evidence indicates further that short-window earnings surprises are negatively and significantly correlated with CDS premia changes in the three-day window surrounding the preliminary earnings announcement, although the impact is concentrated in the shorter maturities.

Conclusion (via U Toronto)

This study examines the relation between CDS and accounting information. Notwithstanding the role of CDS in risk management, overexposure to CDS is seen as one of the drivers of the recent financial crisis. The sharp increase in CDS rates are believed to have played a role in the collapse of Lehman Brothers Holdings Inc. They also likely helped push AIG to seek shelter in the arms of the government (Scannell et al. 2008). At the time this study is written, calls for regulation of CDS have ramped up as these financial instruments have been identified as one of the culprits of the current market stress. The phenomenal growth in CDS market together with the recent financial crisis demonstrate the importance of swaps to the economy, and consequently the need to further study how CDS prices are determined. Our study contributes by showing that earnings levels (changes) are significantly and negatively correlated with the level of (changes in) CDS premia, consistent with earnings conveying information about default risk. Importantly, the impact of earnings on CDS premia is economically significant. At the median, a 1 percent increase in earnings (normalized by total assets) reduces the CDS premium by 9 percent in the levels regression and by 5 percent in the changes regression. Other determinants of CDS premia are also significant and in the directions predicted by the theory.

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07. January 2010 by Miguel Barbosa
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