The information content of the open interest of credit default swaps

Abstract

This article addresses the information content of the open interest of CDS markets. Using a panel database of 481 firms, I show that open interest innovations help to predict subsequent CDS rate changes and stock returns. The open interest dynamics appears to convey specific information on the reference entity and common information. On the one hand, there is evidence that positive open interest growth precedes the announcement of negative earnings surprises, and that high open interest growth prior to these events is linked to positive and significant CDS rate changes. This forecasting power relates with proxies of investors’ attention and market frictions. The predictive power on CDS rates is larger for illiquid contracts and for entities with low credit risk, whereas the predictive power over stock returns is larger for entities that display greater open interest outstanding. On the other hand, this article also shows that the aggregate open interest growth has predictive power on the subsequent returns of CDS and bond main indexes, and to a lesser extent on stock market returns.