Abstract
In this paper, we examine the impact of credit default swap (CDS) trading on the equity market in terms of stock price crash risk. We document that stock price crash is less likely after the inception of CDS trading. This evidence is consistent with the hypothesis that CDS prices reveal negative information that firms intend to hide, and information flow from the CDS market to the equity markets results in timely adjustment of stock prices and reduction of stock price crashes. We provide further evidence of the information revelation role of CDS trading by showing that CDS trading has stronger effects on reducing crash risk when firms are more likely to hide bad news in public disclosures and when executive compensation incentivizes managers to hide bad news. Our paper offers novel evidence on how a financial innovation in the debt market contributes to the stability in the equity market.
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