Internal control quality and credit default swap spreads

Abstract

This paper presents the first study on the effects of internal control quality on derivatives pricing. Specifically, we utilize data from the credit default swap (CDS) transactions of well-monitored companies to examine the relationship between the quality of internal control and the cost of debt. CDS data are advantageous for the study of this relationship because CDS contracts are comparatively more homogeneous, standardized, and liquid than either bank loans or public bonds. We find that, all else being equal, companies experiencing internal control material weakness (MW) exhibit higher CDS spreads than companies with effective internal control. Moreover, the MW effect on CDS spreads is more pronounced for company-level MWs than for less severe, account-specific MWs. We also document that CDS spreads increase around the filings of MWs. Furthermore, the deterioration of internal control quality is related to increases in CDS spreads. Finally, short-maturity CDS spreads are more affected by MWs than are long-maturity CDS spreads.