The Effect of Credit Ratings on Credit Default Swap Spreads and Credit Spreads

Abstract

This paper investigates empirically the relationship between credit spreads and credit default swap spreads, and how these spreads react to changes in credit ratings. Our findings suggest a clear relationship between the two spreads and that credit rating and macroeconomic factors add significant information to this relationship. Furthermore, we find that both spreads react to changes in credit ratings and in particular to downgrades. We discover anticipated and lagged effects of changes in credit rating and differences between investment grades. Interestingly, the CDS market seems to reacts faster and more significantly than the bond market to changes in credit ratings.

Keywords: Credit Risk, Credit Default Swaps, Credit Rating, Principal Component Analysis, Event Study

JEL Classification: G13, G14