Anchoring Credit Default Swap Spreads to Firm Fundamentals

Abstract

This paper examines the capability of firm fundamentals in explaining the cross-sectional variation of credit default swap (CDS) spreads. The paper constructs a fundamental-based CDS valuation by combining the Merton distance-to-default measure with a long list of firm fundamental characteristics. Regressing market CDS quotes against the fundamental valuation cross-sectionally generates an average R-squared of 77%. The cross-sectional explanatory power is stable over time, and robust in out-of-sample tests. Deviations between market quotes and the fundamental valuation predict significantly future market movements. The results highlight the important role of firm fundamentals in differentiating the credit quality of different firms.