This study evaluates the impact of International Financial Reporting Standards (IFRS) on the pricing of credit risk in the over-the-counter Credit Default Swap (CDS) market. The CDS is essentially a “pure” credit default instrument that provides a far less noisy measure of credit risk by comparison to corporate bonds or credit ratings. Callen, Livnat, and Segal (2009) show that U.S. GAAP earnings are an important determinant of CDS spreads. In their levels analysis, they find that a one percent increase in earnings (normalized by total assets) reduces CDS spreads by a non-trivial nine percent. The intent of this study is to compare the credit risk information conveyed by IFRS earnings relative to local GAAP earnings for countries where IFRS are mandatory.
In their seminal study, Duffie and Lando (2001) show theoretically that CDS spreads are negatively correlated with the transparency of accounting information because transparency reduces the noise about the reference firm’s asset structure and wealth dynamics. The adoption of IFRS provides a unique research opportunity to examine the impact of accounting information transparency on the relation between credit risk and financial statement information, particularly earnings. However, any increase in accounting information transparency as a result of IFRS adoption is potentially contingent on country level institutional factors that complement accounting standards and shape financial reporting incentives.
The extant prior literature documents that institutional factors are associated with the quality of accounting information (e.g. Ahmed, Neel, and Wang 2010, Chen, Tang, Jiang and Lin 2010, Alford, Jones, Leftwich and Zmijewski 1993, Ali and Hwang 2000, Bartov and Goldberg 2001, Bushman and Piotroski 2006, Ball, Kothari and Robin 2000). Thus, we examine the variation in institutional factors on CDS spreads including the system of laws (code vs. common law – a proxy for quality of financial statement information), the quality of securities law enforcement, the pervasiveness of earnings management, the extent of differences between local GAAP and IFRS and the level of conservatism. More fundamentally, the change from local GAAP to IFRS should induce higher transparency at firm level. Therefore, we also investigate the effect of IFRS-induced transparency at the firm level on the informativeness of earnings with respect to credit risk using two transparency metrics based on analyst forecasts.
Our study is guided by the theoretical CDS pricing models of Merton (1974) and Duffie and Lando (2001). The latter model provides justification for the relevance of noisy accounting information as a determinant of CDS prices. Although accounting plays no role in the former, the Merton model motivates the need to control for other determinants of CDS spreads. We focus our analysis on accounting earnings and book values of equity as proxies for the firm’s uncertain wealth and noisy asset dynamics. To the extent that these are meaningful proxies, the hybrid CDS pricing model of Duffie and Lando (2001) predicts an inverse relation between CDS spreads and earnings and CDS spreads and book values.
We measure the informativeness of earnings (book values) with respect to credit risk by the earnings (book value) coefficient in a regression of CDS spreads on normalized earnings (book values) controlling for other potential determinants of the spread. The more negative the coefficient, the more informative the credit risk information conveyed by earnings (book values). We use these coefficients to test the relation between financial statement variables and CDS spreads, rather than simple correlations, in order to allow for a richer, more powerful analysis.
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Credit Risk and IFRS: The Case of Credit Default Swaps
