Anchoring Credit Default Swap Spreads to Firm Fundamentals

Abstract:     
This paper examines the capability of structural models, and more generally firm fundamental characteristics, in explaining the cross-sectional variation of credit default swap spreads. The paper starts with a new implementation of the Merton (1974) structural model, highlighting its cross-sectional explanatory power, and then proposes a Bayesian shrinkage method to combine the additional predictions from a long list of firm fundamental variables. A comprehensive analysis based on 579 U.S. non-financial public firms over a period of 351 weeks shows that, with the new implementation, the structural model can explain over 65% of the cross-sectional variation on average. Incorporating additional fundamental variables can increase the average cross-sectional explanatory power to 77% while also making the performance more uniform over time. Furthermore, deviations between market observations and fundamental-based valuations generate statistically and economically significant forecasts on future market movements in credit default swap spreads.

Number of Pages in PDF File: 65

Keywords: structural model, firm fundamentals, credit default swap, cross-sectional variation, relative valuation

JEL Classification: C11, C13, C14, G12

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