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THE RELATIONSHIP BETWEEN CREDIT DEFAULT SWAP SPREADS, BOND YIELDS, AND CREDIT RATING ANNOUNCEMENTS

The field of LRSPs cited by the second highest number of respondents was, broadly speaking, asset identification/categorisation. This includes, for example, the designation of permissible investments and/or required investments for mutual funds as well as the establishment of, and exceptions to, investment concentration limits for particular types of assets. In most cases, member jurisdictions reported that credit ratings were used in both the banking and securities sectors. In addition, the United Kingdom Financial Services Authority (UK FSA) noted that credit ratings are not used in any of its three financial sectors for asset identification. In the EU, the Undertakings. | THE RELATIONSHIP BETWEEN CREDIT DEFAULT SWAP SPREADS BOND YIELDS AND CREDIT RATING ANNOUNCEMENTS John Hull Mirela Predescu and Alan White Joseph L. Rotman School of Management University of Toronto 105 St George Street Toronto ONM5S 3E6 Canada e-mail addresses hull@rotman.utoronto.ca mirela.predescu01@rotman.utoronto.ca awhite@rotman.utoronto.ca First Draft September 2002 This Draft January 2004 Joseph L. Rotman School of Management University of Toronto. We are grateful to Moody s Investors Service for financial support and for making their historical data on company ratings available to us. We are grateful to GFI for making their data on CDS spreads available to us. We are also grateful to Jeff Bohn Richard Cantor Yu Du Darrell Duffie Jerry Fons Louis Gagnon Jay Hyman Hui Hao Lew Johnson Chris Mann Roger Stein and participants at a Fields Institute seminar meetings of the Moody s Academic Advisory Committee a Queens University workshop and an ICBI Risk Management conference for useful comments on earlier drafts of this paper. Matthew Merkley and Huafen Florence Wu provided excellent research assistance. Needless to say we are fully responsible for the content of the paper. THE RELATIONSHIP BETWEEN CREDIT DEFAULT SWAP SPREADS BOND YIELDS AND CREDIT RATING ANNOUNCEMENTS Abstract A company s credit default swap spread is the cost per annum for protection against a default by the company. In this paper we analyze data on credit default swap spreads collected by a credit derivatives broker. We first examine the relationship between credit default spreads and bond yields and reach conclusions on the benchmark risk-free rate used by participants in the credit derivatives market. We then carry out a series of tests to explore the extent to which credit rating announcements by Moody s are anticipated by participants in the credit default swap market. 2 THE RELATIONSHIP BETWEEN CREDIT DEFAULT SWAP SPREADS BOND YIELDS AND CREDIT RATING ANNOUNCEMENTS Credit derivatives are .