Active CDS Trading and Managers' Voluntary Disclosure
Also published as Singapore Management University School of Accountancy Research Paper No. 2015-27
We investigate how the development of the credit default swap (CDS) market affects firms’ voluntary disclosure choices. The CDS market has been criticized, inter alia, for (i) its vulnerability to insider trading by informed lenders who trade on borrowers’ private information, and (ii) the reduction in lenders’ monitoring efficiency due to their ability to shed credit risk exposure via CDSs. Consistent with voluntary disclosure theory, we predict that informed trading by lenders and the consequent threat of private information revelation in the spreads of actively traded CDSs will pressure managers to enhance their voluntary disclosures to mitigate the risks associated with non-disclosure. Further, the reduction in lender monitoring will lead shareholders to intensify their own monitoring efforts and demand increased voluntary disclosures from managers. Consistent with these predictions, we find that managers are more likely to issue earnings forecasts and to forecast more frequently when their firms have actively traded CDSs. Our results also suggest that liquid CDSs discipline managers to disclose bad news earnings forecasts, despite their career- and wealth-related incentives to withhold adverse information. In addition to disclosure via management forecasts, we document that liquid CDSs also enhance disclosure via firm-initiated press releases. Our findings suggest that the allegedly negative attributes of the CDS market could result in a positive externality for capital markets by eliciting enhanced voluntary disclosures and thus contribute to a richer information environment.