The Impact of Earnings on the Pricing of Credit Default Swaps

Abstract

This study evaluates the impact of earnings on credit risk in the Credit Default Swap (CDS) market using levels, changes, and event study analyses. We find that earnings (cash flows, accruals) of reference firms are negatively and significantly correlated with the level of CDS premia, consistent with earnings (cash flows, accruals) conveying information about default risk. Based on the changes analysis, a 1 percent increase in ROA decreases CDS rates significantly by about 5 percent. We also find that (i) CDS premia are more highly correlated with below-median earnings than with above-median earnings and (ii) CDS premia are more highly correlated with earnings of low rated firms than with earnings of high rated firms. Evidence indicates further that short-window earnings surprises are negatively and significantly correlated with CDS premia changes in the three-day window surrounding the preliminary earnings announcement, although the impact is concentrated in the shorter maturities.

Keywords: Credit Default Swaps, Earnings, Default Risk, Cash Flows, Accruals

JEL Classification: M41, G13, G20, G32