Term Structure of Credit Default Swap Spreads and Cross-Section of Stock Returns
University of Toronto, Rotman School of Management
San Francisco State University
March 1, 2011
McCombs Research Paper Series No. FIN-01-11
AFA 2012 Chicago Meetings Paper
The slope of a firm's term structure of credit default swap (CDS) spreads (five-year spread minus one-year spread) negatively predicts future stock returns. Stocks with low CDS slope on average outperform stocks with high CDS slope by over 1% each month for the next six months. Our result can not be explained by standard risk factors, stock characteristics, default risk measures or changes in CDS spreads. We find that CDS slope positively predicts future changes in CDS spreads, but the information content of CDS slope only slowly gets incorporated into stock price. CDS slope predicts return mainly for stocks facing high arbitrage costs.
Number of Pages in PDF File: 43
Keywords: credit default swap, term structure, cross-section of stock return, default risk premium, slow information diffusion
JEL Classification: G12
Date posted: January 7, 2011 ; Last revised: June 18, 2011
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