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Covenant Violation: How Does Cds Market React

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FIN 86098 Research in Finance
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Covenant violation: How does CDS market react?

Abstract
We investigate the difference of loan and firm characteristics between financial covenants violated firms and normal firms; how Credit Default Swap market reacts to the first time and second time violation information and what are the determinants of violation. We find that financial covenants violated firms are more likely to be less matured, growth companies. They also borrow less money per deal than normal companies and more likely to borrow money to repay old debt rather than corporate purposes. In addition, we examine around 100 first time financial covenant violations with available CDS data from 2001 to 2012, and find credit market reacts significantly to the unfavorable first time violation information in almost all the windows. We do not find any impact on CDS spreads for the second time violations. Further, our results indicate that firm operating performance, such as leverage, profit and ROA rather than stock market performance is good measure to predict the probability of financial covenant violation.

I. Introduction
Almost every private loan comes with some ex ante contingencies which can be break into three subgroups: pricing grids, borrowing bases and financial covenants. A grid is used to determine the applicable interest rate of a private loan as a function of one performance measurement, for example, the credit rating of a borrower or the borrower’s leverage ratio. The applicable interest rate is also called performance interest rate of private loan. Another common contingency is borrowing base which means that the total available credit of a private loan is based on the value of collateral, usually accounts receivable or inventory. Moreover, the most important form of contingency in private borrowing is financial covenant. Financial

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