Anchoring Credit Default Swap Spreads to Firm Fundamentals

59 Pages Posted: 15 Mar 2012 Last revised: 29 Jul 2018

See all articles by Jennie Bai

Jennie Bai

Georgetown University - McDonough School of Business; National Bureau of Economic Research (NBER)

Liuren Wu

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance

Date Written: December 6, 2014

Abstract

This paper examines the capability of firm fundamentals in explaining the cross-sectional variation of credit default swap (CDS) spreads. The paper constructs a fundamental-based CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamental characteristics. Regressing market CDS quotes against the fundamental valuation cross-sectionally generates an average R-squared of 77%. The cross-sectional explanatory power is stable over time, and robust in out-of-sample tests. Deviations between market quotes and the fundamental valuation predict significantly future market movements. The results highlight the important role of firm fundamentals in differentiating the credit quality of different firms.

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

JEL Classification: C11, C13, C14, G12

Suggested Citation

Bai, Jennie and Wu, Liuren, Anchoring Credit Default Swap Spreads to Firm Fundamentals (December 6, 2014). Journal of Financial and Quantitative Analysis (JFQA), Vol. 51, No. 5, 2016, Available at SSRN: https://ssrn.com/abstract=2020841 or http://dx.doi.org/10.2139/ssrn.2020841

Jennie Bai (Contact Author)

Georgetown University - McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States

HOME PAGE: http://www.jenniebai.com

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Liuren Wu

City University of New York, Baruch College - Zicklin School of Business - Department of Economics and Finance ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States

HOME PAGE: http://sites.google.com/view/liurenwu

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