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

Abstract

This study examines the relation between narrative risk disclosures in mandatory reports and the pricing of credit risk. In particular, we investigate whether and how the Securities and Exchange Commission (SEC) mandate of risk factor disclosures (RFDs) affects credit default swap (CDS) spreads. Based on the theory of Duffie and Lando (2001), we predict and find that CDS spreads decrease significantly after RFDs are made available in 10‐K/10‐Q filings. These results suggest that RFDs improve information transparency about the firm's underlying risk, thereby reducing the information risk premium in CDS spreads. The content analysis further reveals that disclosures pertinent to financial and idiosyncratic risk are especially relevant to credit investors. In cross‐sectional analyses, we document that RFDs are more useful for evaluating the business prospects and default risk of firms with greater information uncertainty/asymmetry. Overall, our findings imply that the SEC requirement for adding a risk factor section to periodic reports enhances the transparency of firm risk and facilitates credit investors in evaluating the credit quality of the firm.

Is More Always Better? Disclosures in the Expanded Audit Report and Their Impact on Loan Contracting

“…(Diamond 1991), banks' information needs differ from those of equity investors (Wittenberg-Moerman 2008). Given that banks face an asymmetric payoff structure on the loans, their risk assessments are particularly focused on downside risk (Florou and Kosi 2015;Chiu et al 2017), which likely drives their preference for negative information (Ball et al 2008 a,b). In a recent report, the PCAOB indicates that the RMMs disclosed in the expanded audit report should provide information regarding "especially challenging, subjective, or complex aspects of the audit as they relate to the relevant financial statement accounts and disclosures" (PCAOB 2016, 2) and that they should represent "areas of high financial statement and audit risk; unusual transactions; and other significant changes in the financial statements."…”

“…3 However, as Baylis, Burnap, Clatworthy, Gad, and Pong (2017) observe, our knowledge of the role of auditing in private debt markets remains limited. Gaining an understanding of the effects of the expanded audit report on the private debt market provides valuable insights about the usefulness of the expanded audit report because the significantly different payoff structures, risk preferences, and return expectations of shareholders and debt holders (Hasan, Hoi, Wu, and Zhang, 2014;Chiu, Guan, and Kim 2017) suggest that prior evidence based on equity investors may not be relevant for private debt holders. Second, accounting information plays a crucial role in debt contracting (Armstrong, Guay, and Weber, 2010) by helping lenders to assess the probability of interest payment and timely repayment of the loan, and hence the risk of default, as well as to estimate the market value of the underlying collateral (Chen, He, Ma, and Stice, 2016).…”

Customers’ Risk Factor Disclosures and Suppliers’ Investment Efficiency

“…First, critics of the SEC's risk disclosure requirement argue that RFDs are vague and likely to be boilerplate because they are simply qualitative descriptions of all potential risks and uncertainties faced by firms (Malone ). Recent studies (e.g., Campbell et al ; Hope et al ; Chiu et al ) document that RFDs are informative and useful in that they enhance investors’ assessment of firm risk and meanwhile reduce the information asymmetry in the capital market. Unlike previous studies that primarily focus on the information role of RFDs in the capital market, we address the usefulness of RFDs from the perspective of product market participants.…”

“…By mandating a separate risk factor section in corporate filings, the SEC aims to enhance investors' understanding of firms' fundamental risks and to assist investors in making more informed decisions. Although the mandated RFDs are deemed as boilerplate or redundant by critics (Malone 2005), recent papers (e.g., Campbell et al 2014;Hope et al 2016;Chiu et al 2017) document that the amount and specificity of risk disclosures in the annual report increase investors' perception of firm risk, while decreasing information asymmetries in the equity and debt markets. These findings suggest that RFDs are useful to capital market participants.…”

Managerial Risk Tolerance and Corporate Credit Ratings.

“…Credit risk consists of two components, i.e., default risk and information risk. The default risk refers to the likelihood that borrowing firms are unable to honor their obligation to pay interests periodically and principal at the maturity, while the information risk, also called estimation risk, refers to the risk associated with estimating default risk(Duffie and Lando 2011;Chiu, Guan and Kim 2018).…”