Corporate Governance,Economics & Finance

Predicting market trends with credit derivative insights

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Credit default swap

Companies can greatly benefit from the wisdom of the credit default swap market and gain insights that enhance managerial learning, especially during uncertain times

By Putro Harnowo, Senior Content Manager, China Business Knowledge @ CUHK

With the looming threats of inflation and geopolitical tensions, staying on top of macroeconomic developments is crucial. The recent banking crisis serves as a poignant reminder for businesses to stay abreast of financial risks, minimising potential losses and upholding stability.

However, company managers in general operate with imperfect information and may need to learn from external investors who hold unique insights. This outsider knowledge can also be obtained from credit default swap (CDS) trading data, which businesses have used since the early 2000s to gauge the market’s perception of the credit risk of a particular company or industry.

CDS is a derivative contract where the seller compensates the buyer in the event of default by a reference firm. It allows investors to “swap” their credit risk with another investor. Much like an insurance policy, the CDS buyer pays a premium regularly, and the seller pays the security’s value and interest if a default occurs.

As a speculative investment, CDS is actively traded and played a significant role in the 2007-2008 financial crisis, when the now-defunct Bear Stearns and Lehman Brothers issued them to investors on mortgage-backed securities and other derivatives. The surge in US interest rates that year caused widespread mortgage defaults, leading to significant payouts for the affected banks.

credit-default-swap
During the 2007–2008 crisis, CDS played a significant role in bank payouts.

“The role of CDS markets has been widely debated, particularly since the financial crisis of 2007–2008,” says Zhu Chunmei, Assistant Professor of Accounting at the Chinese University of Hong Kong (CUHK) Business School. “Understanding the economic consequences of CDS trading is important for regulatory agencies and practitioners as CDS markets continue to evolve.”

Focusing on the relationship between CDS trading and stock price changes, Professor Zhu, along with Professor Kim Jeong-Bon of the City University of Hong Kong and Professor Christine Wiedman of the University of Waterloo, examined a setting in which stock price informativeness increases after the onset of CDS trading.

They found that managerial learning increases significantly when firms are referenced in any traded CDS contracts, particularly for those facing heightened uncertainty. This aligns with the notion that access to the CDS market gives firms informational advantages related to industry-level and macroeconomic environments.

How CDS can picture market movements

In their paper, Does credit default swap trading improve managerial learning from outsiders?, Professor Zhu and the team argue that managers may learn from CDS trading for three main reasons. Firstly, CDS contracts are primarily traded by dealers who have a vested interest in keeping transaction data private to maintain flexibility in their pricing. This creates strong incentives for CDS market participants to consolidate and analyse information by themselves.

Secondly, the majority of CDS market participants are large financial institutions, which have the resources to generate information that pertains to their investment opportunities, future profitability, macroeconomic developments, and others. Lastly, unlike stocks and bonds, CDS contracts are structured in a way that allows them to be a relatively pure measure of default risk.

“These three advantages lead us to posit that the information generated in the CDS market and transmitted through CDS trading is promptly integrated into stock prices, enhancing stock price informativeness and thus improving managerial learning from stock prices,” says Professor Zhu.

“As the information produced by CDS market participants flows to the stock markets, investors could also learn the information, especially when reference firms’ creditworthiness is deteriorating.”

Professor Zhu Chunmei

CDS are quoted as a “spread”, representing the basis points charged by the seller to the buyer for providing protection. This spread widens with higher perceived credit risk as determined by the supply and demand dynamics. A wider CDS spread suggests that the market views the entity as riskier, and a higher CDS spread means that investors are demanding more compensation for the risk of default.

Benefits of inspecting CDS trading

If managers of reference firms are learning from CDS trading, the information contained in CDS prices should be reflected in the stock prices. To prove this hypothesis, Professor Zhu and the team collected single-name CDS trading data between February 2001 and June 2020 from Markit, a British financial information company that merged with S&P Global in 2022. These data were then compiled with data from Compustat, based on company name, business description, and time, resulting in 893 non-financial American firms that had at least one CDS contract traded during the sample period.

The analyses found that changes in CDS spreads are significantly related to changes in stock prices, and that managerial learning, proxied by the sensitivities of investment to stock prices and of management forecast accuracy to stock returns, increases after CDS trading.

Those results suggest that managers of reference firms are learning from CDS trading and incorporating this information into their investment and forecast decisions. This is particularly visible when CDS market participants are exposed to certain value-relevant information, which means investors who can access CDS data may have an informational advantage over those who do not.

credit-default-swap
Managerial learning increases significantly when firms are referenced in any traded CDS contracts.

Next step, the researcher examined the impact of CDS trading on firms with different levels of uncertainty. Instead of specifying types of industries or settings, the researchers used the uncertainty index and economic policy uncertainty index from the existing studies. The analysis found that managers with high industry uncertainty are likely to learn more from CDS trading than those with low uncertainty.

“As CDS market participants’ informational advantages lie in industry and macroeconomy, the uncertainty level in industry and macroeconomy is one key factor influencing managerial learning from CDS trading,” Professor Zhu adds. “Another key factor is reference firms’ credit risk.”

Given CDS spread can reflect perceived credit risk, the researchers argue that new information is more likely to be produced by CDS market participants when firms’ creditworthiness deteriorates. Specifically, when the buyer of a CDS contract stands to gain a large payout if the reference firm defaults, CDS market participants have strong incentives to collect and monitor information about firms with high credit risk.

The researchers then measured the role of creditworthiness by constructing six subsamples of firms based on three criteria related to credit risk, and conducted analyses for each subsample to gauge the impact of CDS trading. The result implied that CDS market participants engage more intensely in monitoring firms with high credit risk, making managers of such firms learn more from CDS trading.

“As the information produced by CDS market participants flows to the stock markets, investors could also learn the information, especially when reference firms’ creditworthiness is deteriorating,” she adds.

Improving transparency

The researchers then tried to figure out how managers of reference firms learn from CDS trading. The Dodd-Frank Act, a US legislation enacted in the wake of the 2007-2008 financial crisis, has improved access and transparency to CDS trading data with several rules, including the requirement for dealers to report transaction data for certain indexes.

However, the researchers found the number of managers obtaining such reports is not significant. They also found only a meagre amount of news relating to non-financial CDS spreads published on key financial media such as the New York Times, Wall Street Journal, and Washington Post. Given this rarity, the researchers concluded that the managers do not learn directly from the CDS market, but can only do so when CDS pricing data are publicly available.

“Another key implication of this research for the regulator is to enhance the transparency of CDS markets via publicly disclosing the non-pricing and pricing data of CDS trading,” says Professor Zhu. “We find a new benefit associated with CDS trading, and this positive effect of CDS trading should also be considered when the US Securities and Exchange Commission and other regulatory agencies make policies regarding the single-name CDS market.”

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By showing that CDS trading can affect managerial decision-making, the research suggests that financial markets can have real effects on the behaviour of firms and the broader economy. However, as the study was conducted on US data, it is difficult to say whether these findings would hold in other markets, as these jurisdictions have different regulatory environments and market structures.

“For instance, interbank CDS was first introduced in 2016 in Chinese markets, while single-name corporate CDS is a new derivative for investors in Chinese markets,” she adds. “Exploiting the exact and concrete information generated by CDS market participants could be an interesting research opportunity [in the future].”