New generation credit risk models have increasingly recognized the importance of credit contagion, the co-movement of default risk for related firms due to credit events. However, no direct and systematic evidence has been documented to date. Explanations of credit contagion are proposed but segmented. To provide a solid empirical foundation for such models, this paper comprehensively studies the effect of credit deterioration of a corporate on the default risk of its industry counterparts, captured in the Credit Default Swaps (CDS) Market. We systematically document the existence and heterogeneity of within-industry contagion for a broad universe of credit events, including Chapter 11 bankruptcies, Chapter 7 bankruptcies, and financial distress. Our empirical results suggest that industry contagion matters in explaining default risk changes at firm level. In addition, we investigate drivers of credit contagion within a unified framework incorporating macroeconomic, industry and firm-specific factors, and identify two important firm-level determinants undoc umented in prior studies, i.e. the influence power of the distressed firm, and the fragility of its peer firms. This finding is instrumental in explaining the clustering and cascades of credit events during recessions. Furthermore and importantly, our study uncovers the evidence of pure contagion beyond the macroeconomic and industry common factors. Finally, we find that credit contagion is captured in the CDS market in an earlier, cleaner and stronger way than in the stock market. Our results have direct implications on measuring and managing risk of credit portfolios, and can be used to improve credit risk models.
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