Do Credit Default Swaps Mitigate the Impact of Credit Rating Downgrades?

EFA 2012, Copenhagen, 15-18 August 2012

WFA 2013 Tahoe, NV, June 17-20, 2013

52 Pages Posted: 19 Mar 2012 Last revised: 26 Oct 2018

See all articles by Sudheer Chava

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business

Rohan Ganduri

Emory University

Chayawat Ornthanalai

University of Toronto - Rotman School of Management

Date Written: October 2, 2018

Abstract

We find that a firm's stock price reaction to its credit rating downgrade announcement is muted by 44--52% when credit default swaps (CDSs) trade on its debt. We explore the role of the CDS markets in providing information ex ante and relieving financing frictions ex post for downgraded firms. We find that the impact of CDS trading is more pronounced for firms whose debt financing is more dependent on credit ratings (e.g., those rated around the speculative-grade boundary, those with a higher number of rating-based covenants). Reductions in debt and investment, and the increase in financing costs are less severe for CDS firms than non-CDS firms following an identical credit rating downgrade. Our results suggest that CDSs mute the stock market reaction to a credit rating downgrade by alleviating the financing frictions faced by downgraded firms.

Keywords: Credit ratings; Credit default swaps; Financial regulation

JEL Classification: G18, G14, G12, G28, G33, G38

Suggested Citation

Chava, Sudheer and Ganduri, Rohan and Ornthanalai, Chayawat, Do Credit Default Swaps Mitigate the Impact of Credit Rating Downgrades? (October 2, 2018). EFA 2012, Copenhagen, 15-18 August 2012. Available at SSRN: https://ssrn.com/abstract=2023998 or http://dx.doi.org/10.2139/ssrn.2023998

Sudheer Chava

Georgia Institute of Technology - Scheller College of Business ( email )

800 West Peachtree St.
Atlanta, GA 30308
United States

HOME PAGE: http://www.prism.gatech.edu/~schava6/

Rohan Ganduri (Contact Author)

Emory University ( email )

1300 Clifton Rd
Atlanta, GA 30322
United States

Chayawat Ornthanalai

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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