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The Effect of Equity-Market Frictions on Default-Risk Assessment: Evidence from Short-Sale Constraints around the World

73 Pages Posted: 23 Jul 2013 Last revised: 31 Jul 2017

Mark G. Maffett

University of Chicago - Booth School of Business

Edward L. Owens

Emory University - Department of Accounting

Anand Srinivasan

CAFRAL, Reserve Bank of India; National University of Singapore - Department of Finance

Date Written: March 30, 2017

Abstract

We examine how equity-market frictions that restrict pessimistic trading, such as short-sale constraints, affect assessments of default risk. We find that these frictions decrease the usefulness of equity-market variables for identifying defaulting firms but increase their usefulness for identifying non-defaulting firms. Accounting information significantly improves the accuracy of default-risk assessments in the presence of pessimistic-trading frictions, particularly where a country’s institutional infrastructure promotes transparent financial reporting. Yet, the net effect of pessimistic-trading frictions is a reduction in the accuracy of default-risk assessments based on publicly available sources of information. Using an exogenous shock, we document that short-sale constraints lead to higher credit spreads. Overall, our results demonstrate a negative externality of equity-market-based pessimistic-trading restrictions on debt markets arising from a reduction of default-risk-relevant information in equity prices.

Keywords: Short-sale constraints; Default risk; Financial reporting transparency; Credit spreads

JEL Classification: G15, G33, G38, M41

Suggested Citation

Maffett, Mark G. and Owens, Edward L. and Srinivasan, Anand, The Effect of Equity-Market Frictions on Default-Risk Assessment: Evidence from Short-Sale Constraints around the World (March 30, 2017). Available at SSRN: https://ssrn.com/abstract=2296992 or http://dx.doi.org/10.2139/ssrn.2296992

Mark G. Maffett (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

Edward L. Owens

Emory University - Department of Accounting ( email )

Goizueta Business School
1300 Clifton Road
Atlanta, GA 30322
United States

Anand Srinivasan

CAFRAL, Reserve Bank of India ( email )

C-8, 8th Floor, Reserve Bank of India
Bandra-Kurla Complex, Bandra (East)
Mumbai, Maharashtra 400051
India

National University of Singapore - Department of Finance ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore

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