First Draft: September 2002 This Draft:January, 2004
Joseph L. Rotman School of Management, University of Toronto. We are grateful to Moody's Investors Service for financial support and for making their historical data on company ratings available to us. We are grateful to GFI for making their data on CDS spreads available to us. We are also grateful to Jeff Bohn, Richard Cantor, Yu Du, Darrell Duffie, Jerry Fons, Louis Gagnon,Jay Hyman, Hui Hao, Lew Johnson, Chris Mann, Roger Stein, and participants at a Fields Institute seminar, meetings of the Moody's Academic Advisory Committee, a Queens University workshop, and an ICBI Risk Management conference for useful comments on earlier drafts of this paper. Matthew Merkley and Huafen (Florence) Wu provided excellent research assistance. Needless to say, we are fullyresponsible for the content of the paper.
THE RELATIONSHIP BETWEEN CREDIT DEFAULT SWAP SPREADS, BOND YIELDS, AND CREDIT RATING ANNOUNCEMENTS
Abstract A company’s credit default swap spread is the cost per annum for protection against a default by the company. In this paper we analyze data on credit default swap spreads collected by a credit derivatives broker. We first examine the relationshipbetween credit default spreads and bond yields and reach conclusions on the benchmark risk-free rate used by participants in the credit derivatives market. We then carry out a series of tests to explore the extent to which credit rating announcements by Moody’s are anticipated by participants in the credit default swap market.
THE RELATIONSHIP BETWEEN CREDIT DEFAULT SWAP SPREADS, BONDYIELDS, AND CREDIT RATING ANNOUNCEMENTS Credit derivatives are an exciting innovation in financial markets. They have the potential to allow companies to trade and manage credit risks in much the same way as market risks. The most popular credit derivative is a credit default swap (CDS). This contract provides insurance against a default by a particular company or sovereign entity. The company is knownas the reference entity and a default by the company is known as a credit event. The buyer of the insurance makes periodic payments to the seller and in return obtains the right to sell a bond issued by the reference entity for its face value if a credit event occurs. The rate of payments made per year by the buyer is known as the CDS spread. Suppose that the CDS spread for a five-year contract onFord Motor Credit with a principal of $10 million is 300 basis points. This means that the buyer pays $300,000 per year and obtains the right to sell bonds with a face value of $10 million issued by Ford for the face value in the event of a default by Ford.1 The credit default swap market has grown rapidly since the International Swaps and Derivatives Association produced its first version of astandardized contract in 1998. Credit ratings for sovereign and corporate bond issues have been produced in the United States by rating agencies such as Moody's and Standard and Poor's (S&P) for many years. In the case of Moody's the best rating is Aaa. Bonds with this rating are considered to have almost no chance of defaulting in the near future. The next best rating is Aa. After that come A,Baa, Ba, B and Caa. The S&P ratings corresponding to Moody's Aaa, Aa, A, Baa, Ba, B, and Caa are AAA, AA, A, BBB, BB, B, and CCC respectively. To create finer rating categories Moody's divides its Aa category into Aa1, Aa2, and Aa3; it divides A into A1, A2, and A3; and so on. Similarly S&P divides its AA category into AA+, AA, and AA–; it divides its A category into A+, A, and A–; etc. Only the...