Finance Seminar: Dragon Tang
We find that stock crash risk is lower after the inception of credit default swaps (CDS) trading. This finding is consistent with the hypothesis that CDS prices reveal negative information that firms intend to hide, resulting in timely adjustment of stock prices and reduction in the likelihood of future stock price crashes. We further show that the stock crash-reduction effect of CDS trading is stronger when corporate managers make more earnings forecasts or have more equity in their compensation packages. Our paper offers novel evidence on how financial innovations in the debt market improve the stability of the equity market.