Intra-Industry Credit Contagion: Evidence from the Credit Default Swap Market and the Stock Market

Abstract

Motivated by the observation of clustering and cascading of credit events, new generation credit risk models have increasingly recognized the importance of credit contagion. However, the empirical significance of credit contagion has not been assessed to date. To provide a solid empirical foundation for such models, I study the effects of a firm's credit event on the default risk of its industry counterparts, captured in the Credit Default Swaps (CDS) Market. I find that these effects are heterogeneous conditional on the nature of credit events. Industry credit contagion is strongest when a firm is struck by a credit spread shock. It is partially offset by competition effect in the event of Chapter 11 bankruptcies, and is dominated by competition effect around Chapter 7 filings. This finding is consistent with theories of counterparty risk and updating of beliefs. I further investigate drivers of contagion and competition effects within a unified framework incorporating macroeconomic, industry and firm-specific factors. Particularly I identify new factors that help explain the high default correlation during economic downturns. Furthermore, this paper uncovers evidence of pure contagion beyond macroeconomic and industry common factors. Finally, I find that credit contagion is captured in the CDS market in an earlier, cleaner and stronger way than in the stock market. The results can be used to improve credit risk models, and have rich implications for credit-sensitive portfolio management.