Abstract
We document that firms' stock prices react significantly less to credit rating downgrade announcements when credit default swaps (CDS) trade on their debts. The impact of CDS trading is more pronounced for firms with high-information and financing-related frictions. Prior to a rating downgrade, the ability to trade credit risk via CDS generates information flows from the CDS to equity markets, thereby decreasing the informativeness of credit rating downgrades. Ex post, the ability of lenders to hedge in the CDS market mitigates the loss in access to and cost of financing for downgraded firms. While the CDS market is not a perfect substitute for credit ratings, our results suggest that equity investors rely less on credit ratings in the presence of CDS trading.
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