Externalities of Credit Default Swaps on Corporate Disclosure

Abstract

We investigate the externality influence of credit default swap (CDS) trading on management forecasting activity when the reference entity of the CDS is the firm’s customer. We find that firms which derive a greater proportion of their revenue from CDS-referenced customers tend to reduce the frequency of forecast issuance, suggesting that the information revelation in the customers’ CDS market decreases the marginal benefit of disclosure to the supplier, reducing incentives for managers to issue forecasts. When we classify management forecasts based on the nature of the news conveyed in the forecast, we find that the general negative relationship between supplier forecasting activity and trading in CDS-referenced customer firms also manifests for good news forecasts. However, we find that the negative relationship between trading in CDS-referenced customer firms and bad news forecasts varies with the level of ex ante litigation risk. In particular, we find that heightened litigation risk offsets the greater incentive to withhold bad news that would otherwise accompany greater trading in CDS-referenced customer firms. Our results are robust to a variety of sensitivity tests that control for potential self-selection in CDS-referenced customers, and our results strengthen when we focus on supplier firms which themselves are not referenced by CDSs. Our findings add to the literature examining the externality effects of CDSs on corporate decisions of entities outside those directly referenced by CDSs.

Keywords: voluntary disclosure, litigation risk, earnings guidance, credit default swaps, customer-supplier relationship, externalities

JEL Classification: M41, L14