The Impact of Earnings on the Pricing of Credit Default Swaps
37 Pages Posted: 8 Oct 2008
Date Written: December 2006
This study evaluates the impact of earnings on firm credit risk as captured by CreditDefault Swaps (CDS). We find that earnings (changes) are negatively correlated withone-year swap premia (changes) after controlling for equity returns but not with longer term premia (changes). We also find that earnings surprises are significantly correlated with one-year CDS premia changes in the short window surrounding preliminaryearnings dates and that absolute earnings surprises are significantly correlated withabsolute one-year CDS premia changes in the short window surrounding SEC filingdates. These results suggest that high earnings convey favorable information about the short-term default risk of firms but not about the long term default risk. We furtherdocument that accruals/cash flow information conveyed by SEC filings providesinformation about long-term credit risk. Furthermore, the empirical results are consistent with structural and hybrid model-driven implications of CDS pricing.
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