Accounting-Based Versus Market-Based Cross-Sectional Models of CDS Spreads

Abstract

The relevance of accounting data to providers of capital has been strongly debated. In this paper we provide compelling evidence that accounting metrics are important to providers of debt capital. Models of firm distress are mostly either purely accounting-based (e.g. Altman, 1968; Ohlson, 1980) or purely market-based (e.g. Merton, 1974). We examine the information content of accounting-based and market-based metrics in pricing firm distress using a sample of Credit Default Swap (CDS) spreads. Credit Default Swaps are derivatives that offer protection from the event a given firm defaults on its obligations. CDS spreads provide a clean measure of default risk as they are the compensation that market participants require for bearing that risk. Using a sample of 2,860 quarterly CDS spreads available over the period 2001-2005 we find that a model of distress which is entirely composed of accounting-based metrics performs comparably, if not better, than market-based structural models of default. Furthermore, we find that both sources of information (accounting- and market-based) are complementary in pricing distress. These results support the notion that accounting metrics have direct value- or valuation-relevance to debt holders and holders of credit derivatives.

Keywords: credit default swap, credit risk, bankruptcy prediction

JEL Classification: M41, G1, G12, C41, C52