George Batta
DBA in Accounting and Control
Dissertation Chair: Profs. P. Healy and
K. Palepu
Financial Information's Role in Credit Analysis and Credit Derivative Valuation
This thesis examines the role of fundamental analysis through financial information in
credit risk assessment and credit derivative valuation. The first paper examines the mix
of information used by market participants to value credit derivatives, a new type of
financial instrument that allows banks, insurance companies, and hedge funds to take
large, relatively liquid positions on firms' credit risk. I focus on one of the more popular
types of credit derivatives, the credit default swap (CDS). Despite longstanding evidence
on the usefulness of accounting information for credit risk assessment, financial
statement variables play almost no direct role in extant, market-based CDS pricing
models. However, to the extent CDS pricing models estimate credit risk with noise,
owing to noise in model inputs or model misspecification, accounting variables may play
a role in CDS pricing. Empirical findings suggest that bond ratings (and, to a lesser
extent, stock returns) incorporate much of the information in financial reports necessary
to compensate for noise in CDS pricing models, though staleness and coarseness in
ratings designations still causes the market to place incremental, economically significant
weight on accounting information for this purpose. The second paper investigates the
circumstances under which accruals improve earnings' role in credit risk evaluation.
Results of empirical tests suggest that both earnings' and cash flows' explanatory power
for credit derivative price levels is greater for firms with high default risk. However, I
find little evidence that earnings' smoothing function causes its incremental explanatory
power to increase in firms with higher operating cycles, though I find some evidence that
large negative earnings charges decrease earnings' explanatory power for credit
derivative price levels, consistent with a scenario in which conservative accounting helps
generate an income number less useful for future cash flow prediction. Finally, I find
evidence that economic losses improve earnings' explanatory power for credit derivative
spread changes, as conservatism's lower relative verification requirements for negative
economic income allow earnings to more rapidly incorporate economic income into
accounting income in the presence of losses.
