Credit Default Swap Spreads as Viable Substitutes for Credit Ratings

Abstract

We evaluate the viability of credit default swaps (CDS) spreads as substitutes for credit ratings. We focus on CDS spreads based on the obligations of financial institutions, particularly fifteen large financial institutions that were prominently involved in the recent financial crisis. Our data, from 2006-09, show that CDS spreads incorporate new information about as quickly as equity prices, and significantly more quickly than credit ratings. Although CDS spreads did not identify accumulating risk exposures before 2007, they quickly reflected disclosures and developments beginning in summer 2007 at the latest. Thus, CDS spreads are a promising market-based tool for regulatory and private purposes, and they may serve as a viable substitute for credit ratings.

Keywords: credit ratings, credit default swaps, finance, structured finance, event studies

JEL Classification: C10, D40, D43, G12, G18, G28, G38, K20, K22, K23, L10, L40