Price discovery in the CDS market: the informational role of equity short interest

Abstract

This paper documents a negative relation between equity short interest and future returns on credit default swaps (CDS). This relation is most consistent with the theory that equity short interest telegraphs relevant information to secondary market CDS investors about credit spread not transmitted into prices in other ways. The CDS return predictive pattern also strengthens negatively for equity short-interest positions subject to an outward shift in the demand for shortable stocks, which we view as a proxy for the expected benefits of private information (Cohen et al. in J Finance 62(5): 2007). This suggests that features of the shorting market may help explain the lagged response of CDS spreads to equity short interest. Our tests of economic significance, however, do not support the view that the CDS return predictive pattern is strong enough to cover the round-trip cost of trading in the secondary CDS market.Keywords Equity short interest Á Credit default swaps Á Credit spreads Á Lagged asset price discovery JEL Classification G12 Á G14 Á G24 Á M41

The market for credit default swaps: new insights into investors' use of accounting information?

“…Griffin et al . () take an approach similar to Correia et al . ()and use the same baseline model for bond spread and CDS spread changes (model 14), but with the addition of a Merton () default variable to control for distance to default based on publicly available information.…”

“…Griffin et al . () examine the response of the CDS and bond markets to abnormal equity short selling and report two results. First, bond and CDS credit returns help anticipate equity investors' pre‐earnings announcement response to equity short selling.…”

The Effect of Risk Factor Disclosures on the Pricing of Credit Default Swaps

“…; Griffin et al. ) . Therefore, the CDS market offers a relatively clean setting to test the theoretical link between corporate disclosure and credit pricing.…”

“…Compared with bank loans and corporate bonds, CDS contracts are more homogeneous, standardized, and liquid. Because of these unique features of CDS contracts, CDS spreads provide a purer pricing of credit risk and reflect changes in credit risk more accurately and quickly than spreads of other debt instruments (Callen et al 2009;Shivakumar et al 2011;Griffin et al 2016). 2 Therefore, the CDS market offers a relatively clean setting to test the theoretical link between corporate disclosure and credit pricing.…”

“…CDS spreads can be viewed as a cleaner measure of the underlying credit risk than bond yield spreads. For example, CDS spreads do not reflect interest rate risk, currency risk, and other risk features that may relate to covenants, guarantees, and other credit terms in bond contracting (Griffin et al 2016). Thus, examining the impact of RFDs in the context of CDS spreads provides a clearer inference on the role of RFDs in credit pricing than conducting in the context of, for instance, bond yield spreads.…”