The Impact of S&P 500 Index Revisions on Credit Default ...faculty.washington.edu/yli2/research/workingpapers/SPCDS.pdfthe abnormal spread changes in credit default swap (CDS hereafter)

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The Impact of S&P 500 Index Revisions on Credit Default Swap Market

By

Lindsay Baran

Department of Finance

Kent State University

Ying Li

School of Business

University of Washington Bothell

Chang Liu



Zilong Liu



And

Xiaoling Pu*



JEL code: G12, G14

Key words: S&P 500 Index revision, credit default swap (CDS), information,

certification

_________________________

*Corresponding author: Department of Finance, College of Business Administration, Kent State University,

Kent, OH 44240; Phone: (330)672-1200; E-mail: [email protected].

We would like to thank Jim Miller for his insights, the helpful comments from participants in the research

seminar at Kent State University and the 2015 Eastern Finance Association (EFA) annual meeting in New

Orleans.

mailto:[email protected]

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The Impact of S&P 500 Index Revisions on Credit Default Swap Market

May 2015

Abstract

We investigate the impact of S&P 500 Index revisions on the credit default swap

(CDS) market using the abnormal CDS spread changes of event firms over a sample

period of 2001-2012. Our results show that only addition announcements significantly

negatively impact CDS spreads over both short- and long-term windows. The negative

abnormal CDS spread change is more pronounced (1) during the financial crisis period,

(2) for speculative grade firms over the short-term and (3) for investment grade firms

over the long-term. Our findings in the CDS market provide new evidence for the

certification hypothesis in S&P 500 Index revisions literature.

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1. Introduction

Ever since the first documentation of price effects of Standard and Poor’s (S&P)

Index revisions more than two decades ago, researchers have proposed multiple

hypotheses to explain the stock price increases (decreases) associated with addition to

(deletion from) the S&P 500 Index: the stock price reaction to these announcements

should either be information free, resulting from the downward-sloping demand curves

for index stocks; or it should involve information relevant in pricing the newly added or

removed stocks conveyed in the revision decision by S&P. Even though S&P repeatedly

claims that index revisions do not “in any way reflect an opinion on the investment merits

of the company,” past studies examine information related to changes in liquidity,

changes in investor awareness, certification of the performance of the newly added or

removed firms, or certification of the industry of the newly added firms (for example,

Jain, 1987; Dhillon and Johnson, 1991; Chen, Noronha and Singal, 2004; and Cai, 2007).

We examine whether S&P 500 Index revision involves information by exploring

the abnormal spread changes in credit default swap (CDS hereafter) market for the event

firms. If S&P 500 Index revisions do involve information relevant to firm value, we may

be able to observe not only price effects in the stock market, but price effects in other

related markets that reflect fundamentals of the firms, for example, credit market. The

structural model of Merton (1974) states that equity and debt are both contingent claims

on the underlying firm value, which suggests that factors that affect firm value would

influence both equity and bond markets. Previous literature, such as Dhillon and Johnson

(1991), documents that S&P 500 Index addition brings information not only to the equity

market but also to the options and bond markets. If S&P 500 Index revisions involve

information on equity value, then the same information might also impact debt value and

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the CDS market, which is a debt derivatives market in which investors trade credit risk of

individual firms.

Whereas past studies have used bond markets to detect the existence of

information from the S&P 500 Index revisions (Dhillon and Jonson, 1991), our study

looks into the CDS market which provides a more liquid setting (e.g., Longstaff, Mithal,

and Neis, 2005) to examine the reaction of credit market to equity index revision,

especially over short-term windows. We find that when measured as the difference in

average cumulative change of CDS spreads between event firms and the overall CDS

market, the abnormal change of CDS spreads for addition firms is negatively significant

over both short- and long-term windows. The difference in cumulative abnormal changes

between event firms and their industry and size matched peers remains significant, with a

confidence level of 5% or better.

Our findings are potentially consistent with the existence of information in S&P

500 Index revisions. Whereas prior studies establish that information may stem from

improved liquidity, investor awareness, or certification of future performance, we narrow

down the source of such information with the help of the uniqueness of the CDS market.

As participants in the CDS market are usually large institutions that have access to

information (Acharya and Johnson, 2007), it is likely that these institutions are already

aware of the existence of firms that have a presence in the CDS market prior to index

inclusion. We therefore argue that increased investor awareness may not explain our

findings of information captured by the CDS market.

Since the institutional investors who participate in the CDS market specialize in

evaluating credit risk and are sensitive to deteriorating credit conditions at firms with

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CDS contracts, deletion from the S&P 500 Index is unlikely to carry much additional

information to these institutions regarding the CDS spreads. We suggest that this may

explain why there is no significant difference in abnormal CDS spreads upon deletion

announcements.

Prior studies (Hegde and McDermott, 2003; Chen, Noronha, and Singal, 2004;

Becker-Blease and Paul, 2006) find that the positive information conveyed in S&P 500

Index inclusions pertains to sustained stock liquidity improvements. Given that

decreased CDS spreads are also associated with improved CDS liquidity (Bongaerts, de

Jong, and Driessen, 2011; Tang and Yan, 2014), we investigate the liquidity hypothesis

by (1) examining the effect of improved stock liquidity on the abnormal CDS spread

change following index additions and (2) exploring the liquidity change in the CDS

market. We do not find that the improvement in stock liquidity of addition firms to be

associated with the observed cumulative abnormal CDS spread changes. Neither do we

find significant liquidity improvement in the CDS market after a stock is added to the

S&P 500 Index. Thus, the liquidity hypothesis is unable to explain our findings.

We suggest that the certification hypothesis could explain our results, as

certification hypothesis argues that S&P 500 Index additions involve information on an

added firm’s future operating performance, potential longevity, or representativeness in

that firm’s industry (Dhillon and Johnson 1991; Denis, McConnell, Ovtchinnikov, and

Yu, 2003). Further subsample analyses show that the magnitude of the CDS spread

reaction varies with conditions that influence the correlation between markets. For

example, the cumulative abnormal CDS spread is more pronounced during the 2008-2009

financial crisis period when the correlation between equity and credit markets is higher.

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The difference is also more pronounced for addition firms with speculative grade rating

over short-term windows, even though it is more pronounced for addition firms with

investment grade rating over long-term windows. As correlation influences information

transmission and certification effect is stronger for lower rated firms, we maintain that

our findings provide new evidence that supports the certification hypothesis.

Our study contributes to several strands of literature. First, we find persistent and

significantly negative CDS cumulative abnormal changes for addition firms into the S&P

500 Index over both short- and long-term windows. Few studies explored the index

revision effect on credit markets (Dhillon and Johnson, 1991). Our study expands this

earlier work using the more liquid CDS market which facilitates quicker incorporation of

information than the corporate bond market (Blanco, Brennan, and Marsh, 2005).

Second, whereas it is challenging to distinguish empirically various hypotheses that

attempt to explain the S&P 500 Index addition effect (Shleifer, 1986), we narrow down to

the certification hypothesis as the most likely explanation for our findings in the CDS

market through various tests. We show that not only does credit quality play a role in the

magnitude of abnormal CDS spread changes upon S&P 500 Index revision, but the

timing of addition announcements matters. Consistent with the certification hypothesis,

CDS spreads respond more favorably during financial crisis period when overall market

credit risk is high.

The remainder of the paper is organized as follows. Section 2 reviews literature.

Section 3 describes the sample and provides descriptive statistics. Sections 4 present the

main findings. Section 5 conducts additional tests, and Section 6 concludes.

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2. Literature review and motivation

Prior studies document a stock price reaction to inclusion in or removal from the

S&P 500 Index. These studies find permanent stock price increases after S&P 500 Index

inclusion and temporary stock price declines upon S&P 500 Index removal. One prior

study (Dhillon and Johnson, 1991) explored the impact of S&P 500 Index revisions on

the credit market using bonds, but there is little knowledge of the impact on the credit

derivatives market.

To explain the stock price reaction after S&P 500 Index revision announcements,

researchers have proposed several explanations which can be categorized into five

competing hypotheses.1

The first hypothesis, downward-sloping demand curve

hypothesis, argues that there is no information conveyed in S&P 500 Index revisions and

the price effect arises because non-index stocks are imperfect substitutes for index stocks

(Scholes, 1972). This hypothesis is supported by some previous work (Shleifer, 1986;

Lynch and Mendenhall, 1997; Kaul, Mehrotra and Morck, 2000; Greenwood, 2005). A

second explanation is that temporary price pressure from index fund rebalancing drives

these price changes (supported by Harris and Gurel, 1986; Elliott and Warr, 2003;

Shankar and Miller, 2006; Hrazdil, 2009). Given that these two hypotheses are primarily

related to the supply and demand for stocks, our exploration of the credit market in this

study cannot lend additional support nor rule out these hypotheses.

The remaining three hypotheses concur that index revisions are not information-

free events but each proposes a different form of information transmission. The

certification hypothesis deals with whether S&P 500 Index inclusion or removal conveys

1 A more detailed description of the literature about these hypotheses can be found in Kappou, Brooks, and

Ward (2008) and Baran and King (2012).

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unknown information about future performance to explain the price response to

announcements. Jain (1987) provides empirical evidence that S&P 500 Index addition

conveys information to investors, which might change their perceptions of the stocks.

Dhillon and Johnson (1991) investigate stock, bond, and option prices around the

announcements of the listings in the S&P 500 Index and find bond and option prices to

move with stock prices from 1978 to 1988, suggesting that there is information involved

in these announcements that impacts the equity, debt, and option markets. Denis,

McConnell, Ovtchinnikov and Yu (2003) and Platikanova (2008) also argue that addition

to the S&P 500 Index is not information free by discovering earnings improvement

around the announcement date. In addition, Cai (2007) finds the positive addition

information may spread to the industry of the company.

On the other hand, Shleifer (1986) confirms the positive price effects after the

S&P 500 Index inclusion but argues that the inclusion does not mean that the firm has

good quality since the abnormal returns are not related with the bond ratings. Harris and

Gurel (1986) state that the addition events to the S&P 500 Index do not carry specific

information since the stock prices reverse back over the 30 days following the

announcement in their sample. Beneish and Gardner (1995) support this argument by

investigating the price and the trade volume of newly listed Dow Jones Industrial

Average firms. Hrazdil and Scott (2009) find that improved earnings following index

inclusions are due to these firms’ larger discretionary accruals, not because of the

information effect from the additions.

The investor awareness hypothesis draws on the observation that the price

responses to inclusion and removal are asymmetric. Chen, Noronha and Singal (2004)

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show that the shadow cost (Merton, 1987) declines upon inclusion due to increased

investor awareness but does not decline on index removal since investors do not become

unaware of removed stocks. Finally, the liquidity hypothesis proposes that inclusion to

the index brings sustained improvements in stock liquidity and reductions in bid-ask

spread, consistent with an increase in price. Amihud and Mendelson (1986) propose that

firms included into the S&P 500 Index tend to attract more institutional holdings and

larger trading volume. This trend leads to less information asymmetry and the stock

becomes more liquid, which moves the stock price upward. Following this explanation,

Beneish and Gardner (1995), Chung and Kryzanowski (1998), Hegde and McDermott

(2003), Chen, Noronha and Singal (2004), and Becker-Blease and Paul (2006) find

consistent empirical evidence from the S&P 500 Index and other U.S. market indices.

Dhillon and Johnson (1991) demonstrate that information is involved in S&P 500

Index additions by showing price effects in bonds and options markets. The CDS market

is more liquid than the bond market as new information is impounded into CDS spreads

more rapidly than into corporate bond prices (Blanco, Brennan, and Marsh, 2005). This

feature of the CDS market adds to the benefits of investigating the credit market reaction

using the CDS spreads. If S&P 500 Index revision announcements carry information,

inclusion into the index should be associated with abnormal CDS spread decrease and

exclusion from the index should be associated with abnormal CDS spread increase. By

examining the market reaction in the CDS market which trades on information that is less

driven by changing demand for index stocks, we can focus on whether information in

S&P 500 Index revision announcements affects the credit market and how such

information is impounded.

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Certain features of the CDS market also help us differentiate the channels through

which the information involved in the announcements impounds into the credit market.

For example, since participants of the CDS market are usually institutional investors who

are well-informed (Acharya and Johnson, 2007), we do not expect the announcements to

change the awareness of the CDS reference entity.2

If information is involved in the S&P 500 Index revision announcements, the

reaction in CDS market would vary with the level of integration between equity and

credit markets. Previous literature has documented a low correlation between stock

returns and credit spread changes (Collin-Dufresne, Goldstein, and Martin, 2001; Blanco,

Brennan, and Marsh, 2005). However, correlations between equity and credit markets

are also higher in the crisis (Kapadia and Pu, 2012) as market integration is higher in

financial crises (Bekaert, Harvey, and Ng, 2005). Thus it is possible that the S&P 500

Index revision information would have more pronounced effect on the CDS market in the

recent 2008-2009 crisis.

Previous studies (e.g., Kapadia and Pu, 2012) also document that firms with low

credit ratings usually have larger correlations between stock returns and credit spread

changes than investment grade firms. This suggests that the information from the equity

market may have more influence on speculative grade firms since correlations between

equity returns and credit spread changes are larger in these firms. In particular, if the S&P

500 Index addition announcements contain positive information about the firm, we

expect that firms with higher default risk will benefit more.

2 CDS contract provides insurance against a default by a firm, which is known as the reference entity (Hull,

Predescu, and Whilt, 2004)

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3. Data and sample statistics

3.1. Sample construction

We analyze the abnormal changes in the CDS spreads whose underlying reference

firms were added into or removed from the S&P 500 Index from January 2001 to

December 2012.3 The S&P 500 Index revision events are hand-collected from changes in

the monthly lists of index constituents in Compustat (Baran and King, 2012). We then

use the Lexis-Nexis news retrieval system to verify the announcement day of the index

revisions. The sample excludes stocks which were added due to a merger or takeover,

spinoff, or change in share and contains a total of 248 addition and 241 deletion firms.

We obtain information on stock returns and number of shares outstanding from the

Center for Research in Security Prices (CRSP), and relevant firm-level financial data

from the quarterly updated Compustat database.

We collect information on CDS spreads, depth, and rating from Markit, a leading

provider of CDS data for price discovery, risk and valuations, and end-of-day price

updates. There are 989 North American firms in our CDS data from Markit in the period

from 2001 to 2012. We use the five-year CDS spreads since they are the most liquid

among different maturities. The CDS spreads represent the premium that the insurance

buyer pays to exchange for the residual value of the debt from the insurance protector in

case default occurs. We use the “composite credit rating,” which is the average rating of

Fitch Ratings, Moody’s Investors Service, and S&P’s rating services, provided in Markit

as our measure of credit rating.

3 Our sample of S&P 500 Index changes includes a longer time period, however we limit the time period

given the data availability on CDS spreads in the Markit database.

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Even though Markit has quite thorough coverage of the CDS markets, not every

firm has CDS contracts traded on them. After merging with the Markit database, we find

128 addition firms and 152 deletion firms with available CDS data. Further, we require

event firms to have CDS spread observations around the announcement dates. Our final

sample contains 63 newly added firms and 42 firms that are dropped from the S&P 500

Index. Each year the number of firms which are added into or removed from the index

varies. In our sample, more firms are added into the index in 2006 and 2007. Among the

addition firms, 42 firms have investment grade ratings (ratings of BBB or above) and the

remaining firms have speculative ratings (ratings that are below BBB) in the Markit

database.

To ensure that credit rating changes do not confound our findings, we examine the

credit rating change history for each event firm around the index revision announcements.

There are no credit rating changes for all short-term windows up to 15 days after the

announcements. We find multiple credit rating changes for 13 firms over long-term

windows, but the changes are usually in nearby rating categories, for example, from AA

to A and back to AA. We believe that these rating changes do not confound our long-

term results either.

3.2. Summary statistics

Panels A and B of Table 1 present the summary statistics for 63 addition firms

and 42 deletion firms, respectively. We compute the statistics across all the observations

in the whole sample period. CDS spread is the daily composite five-year CDS spread in

basis points. Market capitalization is calculated by the daily stock price times the number

of shares. Equity volatility is the annualized standard deviation calculated based on daily

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returns. Leverage is equal to the ratio of book value of debt to the sum of book value of

debt and market capitalization. The book value of debt is computed as the sum of long-

term debt and current liabilities in debt. Return on assets (ROA) is defined as net income

divided by total assets. Market-to-book ratio is defined as the ratio of market value to

book value of equity.

We notice major differences between addition and deletion firms in terms of their

average size: the market capitalization is $11.33 and $6.13 billion, and total assets are

$33.60 and $10.33 billion, respectively. Even though both groups have similar average

leverage, the profitability and valuation ratios are higher for the addition firms, with ROA

of 1.01% for newly included firms, compared to 0.41% for the deletion firms. Despite

similar leverage levels, we observe that the average CDS spread for the addition firms is

144.89 basis points (bps), much lower than the average spread for deletion firms of

229.68 bps.

Furthermore, in untabulated results, we compare firm characteristics between

those with and without CDS contracts for all firms that have had S&P 500 Index

revisions. There is no significant difference in size, equity volatility, leverage, ROA, total

assets, and market-to-book ratio between our sample firms and the group without CDS.

This suggests that our sample is not contaminated by selection bias.

[Table 1 about here]

4. Effect of S&P 500 Index Revision on CDS Spreads

Addition to and deletion from the S&P 500 Index involve asymmetric stock price

responses, as documented in Chen, Noronha, and Singal (2004). In this section, we

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investigate the effects on abnormal CDS spreads from the S&P 500 Index revisions in

both the short- and long-term.

4.1. Short-term effects on abnormal changes of CDS spreads

Table 2 reports the market adjusted cumulative abnormal changes of CDS spreads

for event firms in various short-term windows. We use the cross-sectional CDS spread

average from the whole Markit CDS sample as the benchmark index to calculate market

adjusted abnormal CDS spread changes. The abnormal change for an event firm is

computed as the difference between the firm’s CDS spread changes ((CDSit - CDSit-1)/

CDSit-1) and the market CDS spread changes, i.e., the average change of all available

CDS spreads in our CDS Markit sample, computed as ((CDSmt - CDSmt-1)/ CDSmt-1) where

𝐶𝐷𝑆𝑚𝑡 =∑ 𝐶𝐷𝑆𝑗𝑡𝑁𝑗=1

𝑁.4 We apply cross-sectional t-tests, sign tests, and signed rank tests to

investigate whether the cumulative abnormal CDS changes are significantly different

from zero. The sign and signed rank tests are non-parametric tests, which do not require

the data to be normally distributed. Although the signed rank test has more statistical

power than the sign test, the latter would have more statistical power for data with

outliers or a heavy-tailed distribution. These two tests are similar to the t-test and serve as

additional robustness checks.

We report the results from both addition and deletion firms.5 For the addition

sample, we find significant reductions in abnormal CDS spreads upon index inclusion.

The CDS spreads react strongly to the inclusion event in the short windows around the

4 We perform the robust tests using (CDSit - CDSit-1) as the spread changes, and the results are similar.

These results are available upon request. 5 In a robustness test, we winsorize the abnormal CDS spread changes at the top and bottom one percentile

levels to mitigate the influence from outliers and compute the cumulative abnormal changes in each event

window. The results are similar as those reported in the paper. The results are not reported here to save

space, but available upon request.

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announcement date. There are strong negative cumulative abnormal changes two days

before the announcement date. For example, in the window [AD-2, AD+1] (AD is the

abbreviation for announcement date), we observe significant cumulative abnormal

change of -1.05 percent. We also observe further negative movement in the credit market

in the windows [AD-2, AD+n], in which n is 15 days or fewer. Our evidence is consistent

with the findings in the equity market,6 which document short-term stock price surge

around the announcement date that a firm is added to the S&P 500 Index (Harris and

Gurel, 1986; Lynch and Mendenhall, 1997).

We do not find significant reactions in the CDS market upon announcement of the

firms’ deletion from the S&P 500 Index in all event windows in similar tests, where the

abnormal CDS spread change is similarly measured. This finding is contrary to those in

the equity market, which document a stock price decline immediately after the

announcement but a reversal after 60 days (e.g., Chen, Noronha and Singal, 2004). As the

CDS market captures the downside risk, CDS market participants probably possess

similar information on the reference entity firm that is deleted from the S&P 500 Index.

Thus unlike its price effect in the equity market, the information of the S&P 500 Index

removal has little or no impact on the CDS market. Due to the insignificant effect of

deletion news on CDS spreads, we focus on addition announcements in our subsequent

analysis.7


6 We also check the stock abnormal returns around the S&P 500 Index revisions [AD-1, AD+1] in our

sample, and find both addition and deletion have strong impact on the stock market, which is consistent

with the previous literature. The results are available upon request. 7 We conduct all the empirical tests described in this paper for both addition and deletion firms and report

only results for addition firms as the results for deletion firms are not significant. These results are available

upon request.

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4.2.Effects on abnormal changes of CDS spreads in the matching sample

We next construct a matching sample by industry and size and compare the

difference in abnormal CDS spread change between the event firms and the matches. As

Spiegel points out in his 2015 EFA Annual Meeting keynote speech (Spiegel and Tookes,

2015), a broad match based on two-digit SIC code may not correct for industry specific

changes among firms as the two firms can be very faraway in the nature of their

businesses. Since the CDS market participants are well-informed, the information that

causes the abnormal CDS spread change upon addition announcements is likely to be

S&P’s confirmation of the reference entity firm’s representativeness in its industry.

Therefore a closer match is desirable to identify the existence of such information.

We identify industry matches based on the four-digit SIC codes of the event

firms.8 Then we choose firms within the same industry and with similar sizes as the

event firms to construct the matching sample.9 Since not every traded firm has CDS data

and S&P 500 Index addition firms are usually large, we find matching firms for about

two thirds (2/3) of the event firms. This further reduces our sample for this analysis to 42

index inclusions. We compare the firm characteristics (size, equity volatility, leverage,

market-to-book ratio) of the matching firms and the event firms. Overall, our matching

sample mimics the characteristics of the event firms quite well, as the t-test statistics of

the differences on market capitalization, total assets, ROA and stock volatility range

between 0.10 and 0.82. The leverage of the matching firms is slightly higher than the

event firms but the difference remains statistically insignificant (t-stat=1.60). The

8 We also use the three-digit and two-digit SIC code to match for industry, and find significant differences

between the newly added firms and SIC matches. 9 We chose firms in the SIC code matching industry, and then select the firms that are closest in size to the

event firms.

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matches also tend to have slightly higher market-to-book ratio (t-stat=1.76). We report

the above in Panel A of Table 3.

The results on the abnormal CDS spread change of the event firms, the matches,

and their differences are presented in Panel B of Table 3. We find that only event firms

have a significantly negative abnormal CDS spread change while their close matches do

not respond to the addition announcements in all event windows. With the close industry

matches based on four-digit SIC code, the difference in cumulative abnormal CDS spread

change between the event firms and the matches is statistically significant in all the short-

term windows, with a confidence level of 5% or better.

To further investigate the effect of addition announcement on the industry, we

investigate whether the cumulative abnormal CDS spread changes vary with event firms’

industry weight. This test is based on arguments in Cai (2007), who shows that as S&P

500 Index addition brings new information to the industry, the stock price reaction of the

matches is smaller in magnitude when the event firm’s industry weight is high. Our

untabulated results from the test find no statistically significant difference for the

abnormal CDS spread changes of the matches in multiple event windows. Therefore,

despite the findings documented in the equity market, we find little evidence that S&P

500 Index addition announcements involve information for matching firms in the CDS

market. Next, we conduct more empirical tests in an attempt to narrow down the possible

explanations for our findings.


4.3. Liquidity effect

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One possible reason for strong reduction of abnormal CDS spread changes in both

short- and long-term is liquidity improvement of the event firms’ CDS contracts after the

addition which reduces information asymmetry and leads to the decrease of credit risk

(Bongaerts, de Jong, and Driessen, 2011; Tang and Yan, 2007). Hegde and McDermott

(2003) make such arguments for the added stocks after S&P 500 Index announcements

by showing a sustained liquidity increase in the added stocks. Many other studies also

document lower bid-ask spreads due to the index addition, such as Shleifer (1986), and

Beneish and Whaley (1996).

To explore this possibility, we investigate the liquidity changes in the CDS market

after the S&P 500 Index addition announcement. We use market depth to measure CDS

liquidity, which computes the number of the contributors for the price quote on each day.

We do not have access to the CDS trading volume data from the Depository Trust &

Clearing Corporation. The bid or ask prices are not available through the Markit database

either, so we do not have these alternative liquidity measures for the CDS market. Instead,

we use market depth, which is widely used in CDS studies (Kapadia and Pu, 2012; Loon

and Zhong, 2014) and properly captures the liquidity level in the CDS market.

Table 4 presents the addition announcement effect on CDS market liquidity in the

full sample, a subsample with investment grade firms only, and a subsample with

speculative grade firms only, respectively. We report the results on liquidity change over

a short-term window in Panel A. Across all the short-term windows around the

announcement date, the average market depth is stable with about six contributors for

each price quote. We do not observe substantial improvement or deterioration of the

credit market liquidity before or after the addition. In several t-tests for the difference two

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days before (AD-2) announcement and n days after announcement (AD+n, n=1, 2, 3, 5,

10, and 15), the t-statistics are all insignificant. The robust results across all the sub-

samples suggest that the CDS market liquidity over short-term does not change because

of the addition events.

Panel B of Table 4 reports the results on liquidity change for the three groups of

firms over long-term windows. Not surprisingly, we do not find significant depth changes

for the event firms in various window lengths. All the t-test statistics in the event

windows are insignificant. The long-term depth does not experience substantial change

due to the addition news, consistent with the previous findings in short-term windows.

Therefore, abnormal CDS spread declines following inclusion cannot be explained by

improvement in CDS liquidity. To see whether improvements in stock liquidity are

related to CDS spread declines, we estimate the impact of the changes in stock liquidity

on the cumulative CDS spread change in a multiple regression setting and find that the

improved stock market liquidity cannot explain our findings.10

In summary, the insignificant liquidity changes in market depth around the

addition event suggest that liquidity is not the main driver for the substantial abnormal

changes in the CDS spreads. This is not surprising, as the CDS market is a contract-based

market where liquidity is less influential (Longstaff, Mithal, and Neis, 2005). Since stock

liquidity does not explain the abnormal changes in the CDS spreads, we conclude that

liquidity hypothesis is not a good explanation for the significant reduction in cumulative

abnormal CDS spread change of the addition firms.


4.4 Effects on abnormal changes of CDS spreads in the long-term

10

We follow Amihud (2002) to measure the stock market liquidity and report these results in Table 8.

20

While many studies (Harris and Gurel, 1986; Hegde and McDermott, 2003;

Becker-Blease and Paul, 2006) examine the short-term reaction of stock prices to S&P

500 Index addition, Chan, Kot, and Tang (2013) investigate long-term effects of S&P 500

Index revisions and document significant price effects. We carry our investigation of

S&P 500 Index addition effect in the credit market to time periods up to three years to

examine whether the addition events convey information to the credit market in the long-

term.11

Specifically, we examine the long-term impact of S&P 500 addition on abnormal

CDS spread changes.

If S&P 500 Index addition carries long-term positive information of the firm, the

credit spreads should decrease and should not reverse in the long-term. Table 5 presents

the long-term cumulative abnormal CDS spread changes in various event windows across

the whole sample. We compare the firm characteristics, such as size, leverage, and

market-to-book ratio, at the beginning and end of the event windows, and do not find

significant difference. However, in one, two, and three years12

after the announcement

date, the CDS cumulative abnormal changes are negative and significant at one percent

level. Our findings suggest that firms added to the S&P 500 Index have shrinking CDS

spreads in the long term. One possible reason could be that these added firms may be

subject to a higher level of scrutiny by investors and analysts which helps to reduce

information asymmetry (Denis, McConnell, Ovtchinnikov and Yu, 2003) and improves

firm performance. The strong CDS price reaction in the long-term suggests that the

favorable information from S&P 500 Index addition is persistent, and the short-term

11

We check the long-term reaction in the abnormal CDS changes of the deletion firms and find that

deletion from the S&P 500 has little impact in the CDS market. Results are available upon request. 12

We assume that there are about 252 trading days in a year so that one-, two-, and three-year windows

correspond to 252, 504, and 756 trading days.

21

decrease in abnormal CDS spreads does not reverse in the long-term. We also checked

the long-term reaction for deletion firms, but did not find significant results.


5. Additional Tests

5.1 Subsample Analysis

Market integration is stronger in the financial crisis (Bekaert, Harvey, and Ng,

2005; Allen and Gale, 2000). If S&P 500 Index addition involves information flow from

the equity market to the CDS market, we expect to observe a more pronounced effect of

the S&P 500 Index additions on the CDS market during crisis periods. Table 6 reports the

results of abnormal CDS changes in various short-term windows in the crisis and non-

crisis periods with the financial crisis period being defined as from 2008 to 2009.13

Out of

the 63 addition firms, there are 13 additions during the financial crisis period and 50 out

of the crisis period.

We find that the cumulative abnormal CDS spread changes are significant in all

the short-term windows when additions occurred during the crisis, but firms with

additions during the non-crisis period experience CDS spread declines that are largely

statistically insignificant. Specifically, in the window [AD-2, AD+1], the average CDS

spread decrease for additions during crisis period is about 2.57 percent, which suggests a

strong reaction in the CDS market to the index inclusion announcement. However, for

additions occurring during non-crisis periods, only in one post-announcement window

([AD-2, AD+10]) is the cumulative abnormal CDS change significantly different from

zero, although all windows show CDS spread declines.

13

We do not examine the events in the dot-com crash of 2002 due to the small sample size.

22

Our observations in Table 6 are consistent with the various studies that report the

low correlations between the equity and credit markets (e.g., Collin-Dufrense, Goldstein

and Martin, 2001; Blanco, Brennan and Marsh, 2005) in the tranquil time period. Thus

even if the S&P 500 Index inclusion announcement involves relevant information on firm

value, it may not be reflected in the CDS spreads during non-crisis periods. Therefore,

our finding that the impact of S&P 500 Index addition is more pronounced during the

crisis could be due to the higher correlation between the stock and credit markets during

this period of time (Kapadia and Pu, 2012) and the contagion effect in the financial crisis

(Allen and Gale, 2000).


Next, we investigate how firms with different credit ratings react to the S&P 500

Index additions in both short- and long-term and report the results in Table 7. Addition to

the S&P 500 Index could be a certification of good quality (Chen, Noronha, and Singal,

2006; Baran and King, 2012), and there will be a differential effect on addition firms with

varying credit quality. Thus, our expectation is that the addition of speculative grade

firms would send stronger positive signals to the credit market than those investment

grade firms, leading to greater reductions in the abnormal CDS spreads.

Out of the 63 addition firms, there are 42 additions with investment grade ratings

and 21 with speculative grade ratings. Consistent with our conjecture, we observe the

average magnitude of cumulative abnormal CDS spread changes for speculative grade

firms is larger than that of the investment grade firms, by about one to five percentage

points in the short-term. For example, in the window [AD-2, AD+5], speculative grade

23

firms have an average of 2.62 percent CDS spread reduction while investment grade

firms do not significantly respond to the index addition news.

Panel B of Table 7 shows an interesting fact that the reaction of speculative grade

firms is not as large as that of investment grade firms in longer windows. In the [AD-2,

AD+252] window, the reaction of the speculative rated firms is stronger than investment

grade firms, while in the ([AD-2, AD+504] window the average cumulative abnormal

CDS spread change of the investment grade firms is more than 10 percentage points

lower than that of the speculative grade firms. This contrasts with the earlier observation

in the short-term windows. Therefore, as addition news provides certification from S&P,

which is both a rating agency and the index provider, speculative grade firms benefit

more in the short-term. For lower rated firms, CDS investors may pay more attention to

the short-term changes in default risk, since they are closely related to the debt valuation

of these firms. Thus, the positive news may have more immediate effect for speculative

grade firms in the short-term. Even though the positive impact does not last over the

long-term, it does not reverse either. In two of the long-term after-announcement

windows, the long-term CDS cumulative abnormal changes for speculative grade firms

are negative and marginally significant. The cumulative abnormal changes for the

investment grade firms are significant for all the long-term windows. These findings are

also consistent with past literature on certification effect, which suggests that it is more

pronounced with smaller and less prestigious firms (Megginson and Weiss, 1991).


Crises are hard to predict and represent a relatively exogenous shock (Lemmon

and Lins, 2003; Chen, Ma, Malatesta and Xuan, 2011). Furthermore, we do not expect

24

demand for index stocks to be stronger during financial crises periods or for stocks with

speculative rating. Even though it is hard to differentiate the demand-related hypotheses

and the certification hypothesis using CDS market responses to S&P 500 Index addition

announcements, we believe that results from our subsample analysis are more consistent

with the certification hypothesis that suggests information is involved in S&P 500 Index

revisions.

5.2 Multivariate Regression Analysis

To explore whether our subsample results remain robust after controlling for other

firm characteristics that influence CDS spreads, we conduct a regression analysis and

present the results in Table 8. The dependent variable is the cumulative abnormal CDS

spread changes in the window [AD-2, AD+15]. Specifically, we control for firm size,

leverage, market-to-book ratio, and ROA, as well as stock liquidity, denoted as Liquidity

and measured following Amihud (2002). We also include two constructed dummy

variables: Crisis that takes value 1 for additions during the crisis period and 0 otherwise;

InvestGrade that takes value 1 for reference entity firms with investment grade and 0

otherwise. Similar to the results in Table 6, the coefficient on Crisis is negative and

significant at the 5% level. In addition, supporting the findings in Table 7, the coefficient

on InvestGrade is positive and significant. The coefficient on Liquidity is not significant.

Since Liquidity is correlated with Crisis (the correlation coefficient is 0.51) and the

estimation may be subject to multicollinearity concerns, we report the results from a

regression without including Liquidity in a separate column (2). The coefficients on

Crisis and InvestGrade remain significant with a slightly better confidence level.


25

6. Conclusions

To the best of our knowledge, this study is the first to provide a comprehensive

analysis of the CDS market reaction to the firms added to or deleted from the S&P 500

Index. During the period from 2001 to 2012, we find that the CDS market reacts

significantly to the favorable addition information in both short- and long-term windows.

Deletion from the index has little impact on the CDS market. Different from the findings

in the equity market, the addition information does not have impact on the industry peers

of the event firms. Liquidity changes in the CDS market are insignificant and do not

explain the cumulative abnormal CDS spread changes. Neither does stock liquidity

improvement.

Our findings show that the CDS market absorbs the S&P 500 Index revision

information in a timely manner during the financial crisis while the effect is weaker in the

non-crisis period. In addition, our results indicate that S&P 500 Index additions convey

more positive information to firms with speculative credit rating in the short run. In the

long run, the investment grade firms have persistent negative abnormal CDS changes

while the results of the speculative grade firms are weaker but do not reverse. These

findings support the hypothesis that addition to the S&P 500 Index provides a quality

certification of the firm. Future research could use an expanded sample of revision firms

to explore other factors that may influence how information flows between the equity and

credit markets.

26

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29

Table 1

Summary statistics

This table presents the summary statistics for the 63 addition firms in Panel A and the 42 deletion

firms’ statistics are in Panel B. Our sample period is from January 2001 to December 2012. CDS

spread is the daily composite five-year CDS spread in basis points. Market capitalization is

calculated by the daily stock price times the number of shares. Equity volatility is the annualized

standard deviation calculated based on daily returns. Leverage is equal to the ratio of book debt

value to the sum of book debt value and market capitalization. Return on assets (ROA) is defined

as net income divided by total assets. Market-to-book ratio is defined as the ratio of market value

to book value of equity. We compute the statistics across all the observations in the whole sample

period.

Panel A: Summary statistics for 63 addition firms

Mean Std. Dev Min 25th Median 75th Max

CDS spread (basis point) 144.89 92.71 29.34 77.72 114.77 196.49 449.29

Market cap. (billions) 11.33 12.65 2.68 5.75 7.26 12.26 71.91

Leverage 0.29 0.17 0.02 0.16 0.28 0.39 0.85

Total assets (billions) 33.60 107.40 3.07 6.59 8.94 14.53 724.84

Return on assets (%) 1.01 0.99 -0.83 0.38 0.70 1.59 3.81

Market-to-book ratio 2.56 1.63 0.67 1.65 2.10 3.16 10.75

Stock volatility 0.41 0.14 0.18 0.32 0.40 0.47 0.94

Panel B: Summary statistics for 42 deletion firms

Mean Std. Dev Min 25th Median 75th Max

CDS spread (basis points) 229.68 158.61 37.42 97.04 223.64 313.62 727.11

Market cap. (billions) 6.13 6.51 1.07 2.29 3.70 7.35 33.21

Leverage 0.30 0.16 0.06 0.21 0.25 0.39 0.75

Total assets (billions) 10.33 11.36 1.87 3.20 5.39 13.63 64.02

Return on assets (%) 0.41 0.96 -1.71 -0.16 0.49 0.86 2.87

Market-to-book ratio 3.72 5.55 0.82 1.32 2.01 3.29 28.00

Stock volatility 0.47 0.13 0.20 0.38 0.46 0.55 0.73

30

Table 2

Short-term CDS cumulative abnormal spread changes for event firms

The table presents market adjusted cumulative abnormal changes of the CDS spreads in various

windows around the announcement day (AD). The third and fourth rows report p values from the

Wilcoxon sign test and Wilcoxon sign rank test, respectively. T-values are reported in the

parenthesis. *, ** and *** represent the statistical significance at the 10%, 5%, and 1% levels,

respectively.

Windows Statistics Addition Firms Deletion Firms

[AD-2, AD+1] Mean -1.05%** 0.85%

t-value (-2.03) (0.50)

Sign test p-val. 0.0052 0.6440

Sign rank p-val. 0.0063 0.4412

[AD-2, AD+2] Mean -1.27%** 0.33%

t-value (-2.15) (0.18)



[AD-2, AD+3] Mean -1.42%** 0.43%

t-value (-2.28) (0.22)



[AD-2, AD+5] Mean -1.52%** 0.54%

t-value (-1.98) (0.23)



[AD-2, AD+10] Mean -3.49%*** -1.41%

t-value (-3.19) (-0.53)



[AD-2, AD+15] Mean -3.33%** -0.56%

t-value (-2.13) (-0.18)



N 63 42

31

Table 3

Short-term CDS cumulative abnormal spread changes in the matching sample

This table presents the summary statistics and market adjusted cumulative abnormal changes of

CDS spreads in the windows around the announcement day (AD) for both the newly added firms

to the S&P 500 Index and a matching sample by four-digit SIC code and firm size. We present

the difference between the abnormal CDS spread changes for the event and matching firms in

Panel A and the comparison of cumulative abnormal CDS spread changes in Panel B. The third

and fourth rows of each block in Panel B report the p values from the Wilcoxon sign test and

Wilcoxon sign rank test, respectively. T-values are reported in the parenthesis. *, ** and ***

represent the statistical significance at the 10%, 5% and 1% levels, respectively.

Panel A: Summary statistics

Event

(1)

Matching

(2)

Difference

(2)-(1) T-value

CDS spread (basis point) 144.90 186.50 41.57 1.59

Market cap. (billions) 11.33 13.75 2.42 0.82

Leverage 0.29 0.34 0.05 1.60

Total assets (billions) 33.60 35.75 2.15 0.10

Return on assets (%) 1.01 1.07 0.07 0.23

Market-to-book ratio 2.56 6.23 3.67* 1.76

Stock volatility 0.41 0.43 0.02 0.67

32

Table 3 (continued)

Panel B: Comparison of cumulative abnormal CDS spread changes

Windows Statistics Event

(1)

Matching

(2)

Difference

(1)-(2)

[AD-2, AD+1] Mean -1.28%** 1.16% -2.44%**

t-value (-2.08) (1.20) (-2.69)

Sign test p-val. 0.1173 0.7552 0.0064

Sign rank p-val. 0.0515 0.3212 0.0120

[AD-2, AD+2] Mean -1.64%** 0.96% -2.60%**

t-value (-2.25) (0.87) (-2.27)

Sign test p-val. 0.0596 0.7552 0.0115

Sign rank p-val. 0.0346 0.5113 0.0137

[AD-2, AD+3] Mean -1.84%** 0.83% -2.67%**

t-value (-2.59) (0.73) (-2.13)

Sign test p-val. 0.0195 1.0000 0.0079

Sign rank p-val. 0.0117 0.7917 0.0273

[AD-2, AD+5] Mean -2.47%*** -0.01% -2.46%*

t-value (-2.93) (-0.01) (-2.00)

Sign test p-val. 0.0079 0.6440 0.4408

Sign rank p-val. 0.0049 0.8202 0.0980

[AD-2, AD+10] Mean -4.22%*** 0.09% -4.30%**

t-value (-3.02) (0.06) (-2.07)

Sign test p-val. 0.0436 0.8776 0.8776

Sign rank p-val. 0.0020 0.7917 0.1509

[AD-2, AD+15] Mean -4.12%** 0.24% -4.36%

t-value (-2.03) (0.14) (-1.63)

Sign test p-val. 0.2800 0.4408 0.6440

Sign rank p-val. 0.0393 0.6805 0.2037

N 42 42 42

33

Table 4

Short-term and long-term market depth changes

Table 4 reports the liquidity changes in the CDS market over different windows. Depth is used as

a liquidity measure, which computes the number of contributors for the price quote. T-values are

reported in the parenthesis. *, ** and *** represent the statistical significance at the 10%, 5% and

1% levels, respectively. Panel A represents short-term results of addition firms and panel B

represents long-term results of addition firms.

Panel A: Short-term liquidity changes

Addition firms Investment grade Speculative grade

AD-2 vs. AD+1 0.0317 -0.1667 0.4286

(0.17) (-0.84) (1.12)

AD-2 vs. AD+2 0.0000 -0.1905 0.3810

(0.00) (-0.93) (0.90)

AD-2 vs AD+3 0.0794 0.0714 0.0952

(0.42) (0.48) (0.20)

AD-2 vs. AD+5 0.0635 0.1905 -0.1905

(0.32) (0.84) (-0.49)

AD-2 vs. AD+10 -0.0635 0.1667 -0.5238

(-0.30) (0.75) (-1.19)

AD-2 vs. AD+15 -0.2857 -0.2857 -0.2857

(-1.56) (-1.45) (-0.73)

Panel B: Long-term liquidity changes

Addition firms Investment grade Speculative grade

AD-2 vs. AD+252 0.0806 0.0000 0.2500

(0.19) (0.00) (0.33)

AD-2 vs. AD+504 -0.1525 -0.1463 -0.1667

(-0.28) (-0.23) (-0.15)

AD-2 vs. AD+756 -0.5385 -0.3684 -1.0000

(-0.77) (-0.41) (-1.17)

34

Table 5

Long-term CDS cumulative abnormal spread changes

This table reports the long-term cumulative abnormal changes of CDS spreads in investment

grade firms and speculative grade firms. T-values are reported in the parenthesis. The third and

fourth rows of each block report the p values of the Wilcoxon sign test and Wilcoxon sign rank

test, respectively. *, ** and *** represent the statistical significance at the 10%, 5% and 1%

levels, respectively.

Windows Statistics All

[AD-2, AD+252] Mean -0.2248***

t-value (-3.32)

Sign test p-val. 0.1299

Sign rank p-val. 0.0011

[AD-2, AD+504] Mean -0.4241***

t-value (-4.21)


Sign rank p-val. <.0001

[AD-2, AD+756] Mean -0.4818***

t-value (-3.40)


Sign rank p-val. 0.0002

N

63

35

Table 6

Short-term CDS cumulative abnormal spread changes in the crisis and non-crisis periods

This table presents market adjusted cumulative abnormal changes of CDS spreads in the event

windows around the announcement day (AD) in the crisis (2008-2009) and non-crisis periods.

The third and fourth rows of each block report the p values from the Wilcoxon sign test and

Wilcoxon sign rank test, respectively. T-values are reported in the parenthesis. *, ** and ***

represent the statistical significance at the 10%, 5% and 1% levels, respectively.

Windows Statistics Crisis Firms Non-crisis Firms

[AD-2, AD+1] Mean -2.57%** -0.66%

t-value (-3.00) (-1.09)



[AD-2, AD+2] Mean -3.07%** -0.80%

t-value (-2.83) (-1.18)



[AD-2, AD+3] Mean -2.86%* -1.05%

t-value (-1.85) (-1.56)



[AD-2, AD+5] Mean -3.50%* -0.10%

t-value (-2.12) (-1.17)



[AD-2, AD+10] Mean -6.04%** -2.83%**

t-value (-2.50) (-2.31)



[AD-2, AD+15] Mean -8.82%** -1.91%

t-value (-2.50) (-1.12)



N 13 50

36

Table 7

CDS cumulative abnormal spread changes by credit ratings

This table reports the addition firms’ market adjusted cumulative abnormal changes of CDS

spreads by credit ratings in both short- and long-term in panel A and B, respectively. Among the 63

addition firms, there are 42 investment grade firms (AAA, AA, A and BBB) and 21 speculative

grade firms (BB, B and CCC). T-values are reported in the parenthesis. The third and fourth rows

of each block report the p values from the Wilcoxon sign test and Wilcoxon sign rank test,

respectively. *, ** and *** represent the statistical significance at 10%, 5% and 1% levels,

respectively.

Panel A: Short-term results

Windows Statistics Investment grade Speculative grade

[AD-2, AD+1] Mean -0.90 -1.36%*

t-value (-1.28) (-2.00)



[AD-2, AD+2] Mean -1.11% -1.60%**

t-value (-1.35) (-2.30)



[AD-2, AD+3] Mean -1.05% -2.17%***

t-value (-1.19) (-3.45)



[AD-2, AD+5] Mean -0.96% -2.62%**

t-value (-0.97) (-2.30)



[AD-2, AD+10] Mean -2.73%** -5.03%**

t-value (-2.43) (-2.09)



[AD-2, AD+15] Mean -1.67% -6.66%**

t-value (-0.94) (-2.23)



N 42 21

37

Table 7 (continued)

Panel B: Long-term results

Windows Statistics Investment grade Speculative grade

[AD-2, AD+252] Mean -0.1721* -0.3302***

t-value (-1.91) (-3.54)



[AD-2, AD+504] Mean -0.4597*** -0.3529**

t-value (-3.52) (-2.27)



[AD-2, AD+756] Mean -0.6185** -0.2085

t-value (-4.11) (-0.70)



N

42 21

38

Table 8

Multivariate regression results

This table reports the multivariate regression results with the recent financial crisis dummy and

credit rating dummy. Our sample period is from January 2001 to December 2012. The dependent

variable is the CDS cumulative abnormal spread changes in the event window [AD-2, AD+15].

Size the market capitalization. Equity volatility is the annualized standard deviation calculated

based on daily returns. Leverage is equal to the ratio of book debt value to the sum of book debt

value and market capitalization. Return on assets (ROA) is defined as net income divided by total

assets. Market-to-book ratio is defined as the ratio of market value to book value of equity. The

Crisis dummy is equal to 1 when the event happened in the crisis defined as the period from 2008

to 2009. The InvestGrade dummy is equal to 1 if the firm has investment grade rating and zero

otherwise. The Crisis dummy is equal to 1 if the event occurred during 2008-2009 and zero

otherwise. Liquidity refers to stock market liquidity, following the measure in Amihud (2002).

*, ** and *** represent the statistical significance at 10%, 5% and 1% levels, respectively.

(1)

[AD-2, AD+15]

(2)

[AD-2, AD+15]

Intercept -0.0807 -0.0626

(-1.28) (-1.11)

Leverage 0.0855 0.0901

(0.76) (0.83)

Size -0.0042 -0.0055

(-0.25) (-0.35)

ROA -0.3507 -0.3599

(-0.59) (-0.61)

Market-to-book ratio 0.0013 0.0011

(0.11) (0.10)

InvestGrade 0.0691* 0.0670**

(1.96) (2.02)

Crisis -0.1035** -0.0997**

(-2.24) (-2.36)

Liquidity 26.6813

(0.21)

N 63 63

Adjusted R2 2.13% 3.83%

Documents

The Impact of S&P 500 Index Revisions on Credit Default ...faculty.washington.edu/yli2/research/workingpapers/SPCDS.pdfthe abnormal spread changes in credit default swap (CDS hereafter)