Reaction of the credit default swap market to the release of periodic financial reports

Highlights

• We study the reaction of the CDS market to the release of periodic financial reports.

• Periodic financial reports contain valuable information for the CDS market.

• There is value relevance of accounting information for the CDS market.

• CDS market reacts to the information content of periodic financial reports with delay.

• Overall, the limited attention phenomenon characterizes the CDS market.

Abstract

This paper studies the reaction of the CDS market to the release of periodic financial reports. The results show that periodic financial reports contain valuable information for the CDS market. This finding supports the value relevance of accounting information for the CDS market. We also find that the reaction of the CDS market to the information content of periodic financial reports is with delay. This implies that the limited attention phenomenon characterizes the CDS market.

Introduction

Numerous studies investigate the behavior of the credit default swap (CDS) market, one of the most prominent of financial markets. CDS is a derivative instrument, which enable market participants to transfer credit risk. CDS, like any other innovation, is a double-edged sword with its own pros and cons. On one hand, it is a financial derivative that has several beneficial functions like enabling risk sharing, mitigating credit exposure, and revealing new information about referenced credit risk. CDS spreads provide a valuable market-based assessment of credit conditions, thus the market acts as an indicator of upcoming credit downgrades by rating agencies (Angelini, 2012). On the other hand, it is perceived as contributing to credit crises. The CDS market, for instance, facilitates unregulated speculative activities and spreads negative views about the financial strength of firms (Stulz, 2010). In addition to the opaqueness of the CDS market, critics point to the negative effect of CDS on bank monitoring incentives and reduction in tendency of lenders to support borrowers in times of distress (Arping, 2014). The role of the CDS market in the financial crisis and financial stability has been debated among regulators, market participants and academics in the post-2018 global financial crisis (GFC) period (see, inter alia, Stulz, 2010; Cont, 2010).

Two features of the literature motivate our study. First, we find that one branch of the CDS literature addresses the importance of accounting variables in CDS pricing and incorporates this information as determinants of CDS spread. Das, Hanouna, and Sarin (2009), for instance, illustrate that accounting-based variables explain approximately two-thirds of CDS spread variation. More importantly, these authors find that accounting-based variables are relevant to CDS spread changes even without the inclusion of firm-specific and market-based variables. Batta (2011) also provides evidence for the role of accounting information in the CDS market, although this author claims that the influence of this information occurs mainly through stock and bond markets. Correia, Richardson, and Tuna (2012) confirm that accounting information, in conjunction with market-based information, plays an instrumental role in explaining cross-sectional variation of CDS spread.

In addition to studies that focus on the role of accounting information in CDS pricing, other studies examine the response of the CDS market to release of segregated accounting information, such as earnings announcements and earnings surprises (see, Greatrex, 2009; Zhang & Zhang, 2013). The key outcome from these studies is that this type of financial disclosure is value-relevant for the CDS market.

Thus, these studies point out the key role of accounting information in influencing the CDS market. Based on this evidence, our hypothesis is that the CDS market reacts to the release of periodic financial reports because these reports contain company-level information.

The second feature of the literature relates to the content of financial reports. Periodic financial reports play a critical role in diminishing information asymmetry and the agency problem between a firm's managers and its shareholders or debtholders.¹ Moreover, according to signaling and agency theories, managers have incentives to voluntarily disclose information to benefit the firm (see, for example, Dainelli, Bini, & Giunta, 2013; Morris, 1987; Watson, Shrives, & Marston, 2002).

According to the US Securities Exchange Act of 1934, companies that hold more than $10 million in assets or have more than 500 shareholders are mandated to file financial reports annually and quarterly with the US Securities and Exchange Commission (SEC). These reports are known as “Form 10-K” (annual) and “Form 10-Q,” (quarterly).² These reports include more than simply accounting information. Various sections, for instance, contain detailed and comprehensive information on the firm. In specific sections of the reports, managers must provide explanations for the performance and condition of the firm. These sections include “Risk Factors,” “Defaults upon Senior Securities,” “Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A),” and “Quantitative and Qualitative Disclosures about Market Risk.” These sections contain valuable information for credit market participants to evaluate counterparty risk as well as default risk of the firm.³

There is a broad literature in finance on textual analysis and measuring qualitative information. The findings of this strand of literature show that negative and positive words in corporate periodic reports, newspaper articles, and investor message boards can affect financial markets (see, for instance, Loughran & McDonald, 2011; Tetlock, Saar-Tsechansky, & Macskassy, 2008). Therefore, besides accounting-based information, we expect the narrative content of other parts of obligatory periodic reports to contain information valuable to the CDS market. We focus on entire reports rather than their segments. To the best of our knowledge, this study is the first attempt to investigate the reaction of the CDS market to release of periodic financial reports. Our main purpose is to determine whether regulatory financial reports are value-relevant for the CDS market.

Considering these evidences, our main objective is to investigate whether periodic financial reports are value-relevant for the CDS market.

We follow the following approaches to address our research question. We adopt a panel data regression model and include two indicator variables to determine the effect of periodic financial reports on the CDS market.⁴ With a panel data setup, our analysis is based on a unique data set covering the period 2004–2015. More specifically, we construct some other panels sorted by leverage level, credit rating, and economic situation (pre-GFC, during the GFC, and post-GFC) to examine whether the CDS spreads of 196 US firms change after release of quarterly and annual financial reports. We evaluate the behavior of the CDS market from 1 day up to 10 days after release of reports.

We generate four main findings. First, we show that periodic financial reports contain valuable information for the CDS market. More specifically, the results show that the indicator variables, which signify the effect of periodic reports on the CDS market, are statistically significant. Second, we find that the reaction of the CDS market to release of reports is delayed, because our indicator variables are not significant on filing dates and the day after filing. Third, we demonstrate that the behavior of the CDS market to the release of financial reports differs across portfolios constructed based on leverage levels, credit ratings, and economic conditions. Fourth, our results reveal that there is a distinction in the response of the CDS market between the releases of annual versus quarterly financial reports. This finding points to the possibility of “window dressing” in the preparation of annual financial reports to impress debt holders or lenders.⁵

Our approach and findings contribute to several strands of the literature. First, we add to studies that show that accounting information contributes to CDS pricing (see, for example, Batta, 2011; Das et al., 2009; Demirovic & Thomas, 2007; Demirovic, Tucker, & Guermat, 2015). Financial reports have not been considered by the literature despite their information richness. Our viewpoint in this research goes beyond only considering accounting information. We investigate the behavior of the CDS market with respect to release of mandatory reports. Our findings on the reaction of the CDS market after release of mandatory reports contribute to the literature on content analysis and qualitative measurement in understanding market behavior.

Second, we contribute to the strand of literature (see, for example, Greatrex, 2009; Zhang & Zhang, 2013) that focuses on the reaction of the CDS market after release of public information. Specifically, we contribute to a related body of literature (see, for instance, Callen, Livnat, & Segal, 2009; Finnerty, Miller, & Chen, 2013; Hull, Predescu, & White, 2004; Jenkins, Kimbrough, & Wang, 2016; Norden & Weber, 2004) that shows that credit rating and earnings announcements both influence CDS spreads. We demonstrate that release of periodic reports affects the market even after controlling for release of this public information.

Third, our results add to studies that examine the efficiency of the CDS market. Several studies investigate this issue in regard to release of public information and find mixed results. Some studies indicate that the CDS market is efficient (see, for instance, Hull et al., 2004; Norden & Weber, 2004; Zhang, 2009; Zhang & Zhang, 2013), while others show that the CDS market is inefficient (see, Batta, 2011; Greatrex, 2009). Jenkins et al. (2016) take a neutral position and suggest that the CDS market is efficient in normal conditions but acts inefficiently in unstable situations. Our findings point toward inefficiency of the CDS market because we document that the reaction of the CDS market to release of financial reports is statistically significant on subsequent days. However, we show that the CDS market behaves less inefficiently during the GFC because, in such periods, the market incorporates new information faster compared to non-GFC periods.

Fourth, our finding, showing a delayed response from the CDS market after release of financial reports, indicates the existence of the limited attention phenomenon in this market. The limited attention theory originates from the work of Kahneman (1973). Hirshleifer and Teoh (2003, p. 5) state that “[l]imited attention is a necessary consequence of the vast amount of information available in the environment, and of limits to information-processing power.” The outcome of investors with limited attention is inefficiency in markets, because such investors may fail to update their beliefs quickly and effectively. This finding is important for regulators' efforts to redesign the structure of financial reporting and to push firms toward providing more transparent information with less required cognitive effort by investors.

Finally, our study adds to the accounting literature that investigates the consequences of financial disclosure (see, inter alia, Bonsall, Leone, & Miller, 2017; Botosan, 2000; Healy & Palepu, 2001; Sengupta, 1998). These studies find that accounting disclosure affects the cost of equity capital, bond ratings, and cost of bonds. We complement these studies by showing that corporate disclosure impacts the CDS market as well.

The rest of the paper proceeds as follows. Section 2 develops our hypotheses. In Section 3, we discuss data, variables, and methodology. Section 4 sets forth the results, while the robustness of the results is investigated in Section 5. Finally, Section 6 concludes.