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Anchoring Credit Default Swap Spreads to Firm Fundamentals

Published online by Cambridge University Press:  16 December 2016

Jennie Bai  and
Liuren Wu
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Abstract

In this article, we examine the extent to which firm fundamentals can explain the cross-sectional variation in credit default swap (CDS) spreads. We construct a fundamental CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamentals via a Bayesian shrinkage method. Regressing CDS quotes against the fundamental valuation cross-sectionally generates an average R2 of 77%. The explanatory power is stable over time and robust in out-of-sample tests. Deviations between market quotes and the valuation predict future market movements. The results highlight the important role played by firm fundamentals in differentiating the credit spreads of different firms.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 51 , Issue 5 , October 2016 , pp. 1521 - 1543
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2016 

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