Does the credit default swap market anticipate or react to credit rating agency announcements? A theoretical and empirical study

Rui Borrego & Marius Krzywon

Student thesis: Master thesis


Since 1909, when Moody’s Investors Service published its first rating, the role of rating agencies has become a central one in financial markets. This ascension though, was not achieved in a straight line, as credit rating agencies from time to time found themselves in the center of financial scandals and crises which made regulators rethink the agencies’ roles. One of the most popular results of the last decades’ financial innovation is the Credit Default Swap, which allows investors to artificially create exposure to a corporation’s debt or to hedge their exposure to it. As their popularity and liquidity increased over the last decades, the Credit Default Swap became central for the process of finding debt prices. Given that credit quality is the key driver for both, credit rating agencies’ grades and credit default swaps prices, a comparison of their assessment of a corporation’s creditworthiness is a natural and relevant issue. On the one hand, credit rating agencies have access to exclusive information and a consolidated position as market informants. On the other hand, the market is constituted by some very sophisticated investors who also use their own proprietary systems and other sources of information to assess the credit quality of their investments. After the recent financial crisis, credit rating agencies find themselves in the middle of criticism by investors who claim that the agencies’ implemented business policy does not deliver information on a corporation’s creditworthiness in a timely and accurate manner. In the present Master Thesis, the question whether The Credit Default Swap market anticipates or reacts to the information supplied by credit rating agencies is analyzed from a theoretical as well as from an empirical point of view. We find that the CDS market indeed anticipates negative credit rating announcements. However, we also gather evidence that negative credit rating announcements do convey entirely new information to the market which is in most cases followed by significant changes in CDS premiums. For positive credit rating events we obtained mixed results which makes a clear verdict, on the question whether the CDS market is also able to anticipate positive rating events, difficult.

EducationsMSc in Finance and Strategic Management, (Graduate Programme) Final Thesis
Publication date2010
Number of pages153