Default prediction around the world : the effect of constraints on pessimistic trading

We examine how equity-market frictions that restrict pessimistic trading, such as short-sale constraints, affect assessments of default risk. We find that these frictions decrease the usefulness of equity-market variables for identifying defaulting firms but increase their usefulness for identifying non-defaulting firms. Accounting information significantly improves the accuracy of default-risk assessments in the presence of pessimistic-trading frictions, particularly where a country's institutional infrastructure promotes transparent financial reporting. Yet, the net effect of pessimistic-trading frictions is a reduction in the accuracy of default-risk assessments based on publicly available sources of information. Using an exogenous shock, we document that short-sale constraints lead to higher credit spreads. Overall, our results demonstrate a negative externality of equity-market-based pessimistic-trading restrictions on debt markets arising from a reduction of default-risk-relevant information in equity prices