Short‐selling and credit default swap spreads—Where do informed traders trade?

Abstract

During the global financial crisis, short‐selling and credit default swaps (CDS) gained notoriety as indicators of financial collapse. This paper extends the literature by examining the relationship between short‐selling and CDS spreads. Results indicate that lagged short‐selling metrics forecast changes in CDS spreads; short‐selling is found to have a positive relationship with CDS spreads. These results are robust to various controls including the supply of stock for short‐selling, changes in CDS spreads, cross‐sectional controls for fixed effects, sub‐group analysis by industry sector, and the use of contemporaneous explanatory variables. This suggests that informed traders prefer to short‐sell the underlying stocks.

Short selling disclosure and its impact on CDS spreads

“…Thus far, empirical studies that analyze short selling's impact on CDS spreads are rare. Prior works either examine short sales' impacts using proxy variables such as utilization -as the amount of stock that is lent for short selling as a percentage of the total amount available for stock lending -and short interest (Lecce et al 2018), or they consider establishing short sale bans to analyze short selling's general impact on the CDS market (such as those by Pereira da Silva 2016a; Pereira da Silva, Vieira, and Viegas Vieira 2016; Ni and Pan 2011; Pu and Zhang 2012).…”

“…Recently, Lecce et al (2018) approach the question of relative information content from the perspective of informed traders' instrument selection. They examine CDS contracts and short selling data between 2006 and 2008 to identify which trading venue first reveals signs of informed trading.…”

“…Thus, we primarily refer to studies by Collin-Dufresne, Goldstein, and Martin (2001), Cossin and Hricko (2001), Ericsson, Jacobs, and Oviedo (2009), , Galil et al (2014), Meine, Supper, and Weiß (2015. Lecce et al (2018). Therefore, our model covers vectors with both company-and market-specific variables, which we derive from previous literature to extract the effects of different short sale event types:…”

“…Further, we follow work by Lecce et al (2018) and to consider returns on equity and dividend payouts as further explanatory variables. assume that the probability of default should tend to negatively correlate with a company's profitability.…”

Institutional quality and sovereign credit default swap spreads

“…Recent studies also examined the predictability of CDS spreads. For example, Lecce, Lepone, McKenzie, Wong, and Yang (2018) found that lagged short-selling metrics forecast changes in CDS spreads. However, we have little understanding about what drives the variations in sovereign CDS spreads.…”