The effect of credit rating announcements on CDS spreads - an empirical study of the European, American and Asian-Pacific CDS markets

Abstract: Credit default swap spreads and credit ratings are two indicators and measures of credit risk. A credit default swap is a type of financial derivative that protects the holder from any losses incurred by the reference entity in the case of a negative credit event, in return for an annual premium, the spread. The main question asked in this essay is whether credit rating announcements have any significant impact on credit default swap spreads. Since ratings are a source of information, spreads should behave in accordance with the type of information being distributed. Positive rating announcements should affect spreads negatively, and negative announcements in the opposite direction. By means of an event study, 216 448 daily credit default swap spreads and 336 Moody’s credit rating events from 152 entities in the European, American and Asian-Pacific credit default swap markets are analysed in terms of abnormal returns to investigate this relationship. It is found that, on an aggregated level, the rating categories possible downgrade and possible upgrade as well as pooled positive events and negative events are statistically significant, i.e. display abnormal returns that are different from zero. On a market specific level, possible downgrades and positive events are significant on the US market. On the EU market, possible upgrades and possible downgrades are significant, and finally on the Asian-Pacific market downgrades, possible downgrades and negative events have a statistically significant impact on CDS spread changes on at least a 10 % level. Consistent with previous research, and with theory, the results confirm a significant effect of credit rating announcements on credit default swap spreads, however positive events are less significant than negative and “possible”- events are more prevalent than actual rating changes.