Credit rating changes and credit default swaps: evidence from financial institutions during the financial crisis

Abstract

In my research I have studied how the credit default swap (CDS) markets react to credit rating changes during the financial crisis from June 30, 2007 to December 31, 2012. I have exclusive concentrated on financial institutions given their important role in the economy and due to the amount of attention they received in the course of the crisis.

I have used credit rating history data from both Standard and Poor's and Moody's and have included both negative (downgrade, negative watch/outlook) and positive (upgrade, positive watch/outlook) rating events to my sample. I am utilizing in my study both the cumulative abnormal returns (CAR) and the buy-and-hold abnormal returns (BHAR) methodologies to assess my hypotheses. In order to avoid contemporaneous rating events I have filtered my rating history data using three specific rules.

I discover that during negative events the CDS markets seem to anticipate credit rating changes.This effect is more pronounced for downgrade and negative watch. For positive rating events only detect some evidence (in upgrade) of market anticipation before the rating announcement day but this is not statistically significant. I further evidence that positive and negative rating events result into an immediate tightening/widening in the CDS spread around the announcement day. However, I only find statistical significance for negative watch/outlook and upgrade using both my methodologies. For downgrade I witness statistical significance solely when using the CAR method.

On average the impact from downgrade and upgrade rating events have a symmetrical effect (in the opposite direction) on the CDS spread. I have further analyzed how the CDS markets respond between credit rating agencies and find that the markets do not value one agency over another during the financial crisis.