How to spot risky investments
Credit ratings based on credit-default swaps can provide transparent and effective signals of default risk
- Financial markets continuously reveal information about the riskiness of assets. Trading data—particularly on credit-default swaps (CDS)—can be used to create a market-based ratings system to assess a firm’s ability to repay debt, according to Chicago Booth’s Drew D. Creal, Robert B. Gramacy, and Ruey S. Tsay.
- The researchers analyzed daily CDS spreads from 2005 to 2011 for 1,500 companies. They transformed the spreads into default probabilities, and used an algorithm to cluster firms into ratings categories.
- Each company was assigned an absolute and a relative rating. Relative ratings allow investors to compare firms’ creditworthiness, especially when those firms have been hit by the same credit shock, which would pull their absolute scores down.
- To compare with S&P’s credit ratings, the researchers mapped S&P’s 25 letter grades (from AAA to C-) into numbers.
- In companies that defaulted, the researchers find that relative ratings provided the earliest signal of trouble ahead (see chart). These firms’ relative ratings hit a “1” or “2”—the equivalent of a C or C- by S&P’s measure—long before the companies actually defaulted.
- Analysts can rate companies whose debt or CDS contracts aren’t traded in the market by comparing them with firms with similar characteristics but whose assets are actively traded, and assigning the same rating.