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Credit Default Swaps and Equity Prices: The Itraxx CDS Index Market

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Abstract

In this paper we provide some early evidence of a link between the iTraxx credit default swap (CDS) index market and the stock market. To our knowledge this is the first paper studying this relationship. Knowledge about the link between stock prices, stock return volatilities and CDS spreads is important not only for risk managers using credit default swaps for hedging purposes, but also to anyone trying to profit from arbitrage possibilities in the CDS market. For a sample of European sectoral iTraxx CDS indexes, a correlation study reveals a tendency for iTraxx CDS spreads to narrow when stock prices rise and vice versa. Furthermore, there is some evidence of firm-specific information being embedded into stock prices before it is embedded into CDS spreads. Stock price volatility is also found to be significantly correlated with CDS spreads and the spreads are found to increase (decrease) with increasing (decreasing) stock price volatilities. Finally, we find significant positive autocorrelation in the iTraxx market.

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  • Byström, Hans N. E., 2005. "Credit Default Swaps and Equity Prices: The Itraxx CDS Index Market," Working Papers 2005:24, Lund University, Department of Economics, revised 15 May 2005.
    • Handle: RePEc:hhs:lunewp:2005_024
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    File URL: http://project.nek.lu.se/publications/workpap/Papers/WP05_24.pdf
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    More about this item

    Keywords

    credit default swap index; stock market index; stock return volatility;
    All these keywords.

    JEL classification:

    • C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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