The credit default swap (CDS) market attracted much debate during the 2008 financial crisis. Opponents of CDS argue that CDS could lead to financial instability as it allows speculators to bet against companies and make the crisis worse. Proponents of CDS believe that CDS could increase market competition and benefit hedging activities. Moreover, an efficient CDS market can serve as a barometer to regulators and investors regarding the credit health of the underlying reference entity. We investigate information efficiency of the U.S. CDS market using evidence from earnings surprises. Our findings confirm that negative earnings surprises are well anticipated in the CDS market in the month prior to the announcement, with both economically and statistically stronger reactions for speculative-grade firms than for investment-grade firms. On the announcement day, for both positive and negative earnings surprises, the CDS spread for speculative-grade firms presents abnormal changes. Moreover, there is no post-earnings announcement drift in the CDS market, which is in direct contrast to the well-documented post-earnings drift in the stock market. Our evidence supports the efficiency of the CDS market.

This paper develops a theoretical framework in which asset linkages in a syndicated loan agreement can infect a healthy bank when its partner bank fails. We investigate how capital constraints affect the choice of the healthy bank to takeover or liquidate the exposure held jointly with the failing bank, and how the bank’s ex ante optimal capital holding and possibility of contagion are affected by anticipation of bail-out policy, capital requirements and the joint exposure. We identify a range of factors that strengthen or weaken the possibility of contagion and bailout. Recapitalization with common stock rather than preferred equity injection dilutes existing shareholder interests and gives the bank a greater incentive to hold capital to cope with potential contagion. Increasing the minimum regulatory capital does not necessarily reduce contagion, while the requirement of holding conservation capital buffer could increase the bank’s resilience to avoid contagion.