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Stock Prices and Stock Return Volatilities Implied by the Credit Market

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Abstract

In this paper we compare equity- and credit investors’ opinions on the price formation in the equity market. More exactly, we invert the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for the firms in the DJIA index. The creditimplied stock prices often deviate significantly from actual stock prices over the longer term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA index. In an attempt to demonstrate potential applications of credit-implied stock prices we construct simple “capital structure arbitrage” trading strategies based on past credit-implied prices. Our strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. We demonstrate how an alternative credit-based “fear gauge”, comparable to the VIX index but emanating from the credit market, can be constructed using the credit-implied volatilities. We call this implied volatility index the Credit-Implied Volatility Index (CIVX) index. Finally, a plot of the entire term-structure of implied volatilities demonstrates a distinct maturity volatility skew.

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  • Byström, Hans, 2013. "Stock Prices and Stock Return Volatilities Implied by the Credit Market," Working Papers 2013:25, Lund University, Department of Economics, revised 14 Feb 2014.
  • Handle: RePEc:hhs:lunewp:2013_025
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    References listed on IDEAS

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    1. Forte, Santiago & Peña Sánchez de Rivera, Juan Ignacio, 2006. "Credit spreads: theory and evidence about the information content of stocks, bonds and cdss," DEE - Working Papers. Business Economics. WB wb063310, Universidad Carlos III de Madrid. Departamento de Economía de la Empresa.
    2. Norden, Lars & Weber, Martin, 2004. "The comovement of credit default swap, bond and stock markets: An empirical analysis," CFS Working Paper Series 2004/20, Center for Financial Studies (CFS).
    3. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    4. Acharya, Viral V. & Johnson, Timothy C., 2007. "Insider trading in credit derivatives," Journal of Financial Economics, Elsevier, vol. 84(1), pages 110-141, April.
    5. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    6. Avino, Davide & Lazar, Emese, 2012. "Rethinking Capital Structure Arbitrage," MPRA Paper 42850, University Library of Munich, Germany.
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    Cited by:

    1. Hans Byström, 2015. "Credit‐Implied Equity Volatility—Long‐Term Forecasts and Alternative Fear Gauges," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 35(8), pages 753-775, August.
    2. Byström, Hans, 2016. "Credit-implied forward volatility and volatility expectations," Finance Research Letters, Elsevier, vol. 16(C), pages 132-138.

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    More about this item

    Keywords

    credit default swaps; implied volatility; implied stock prices; CreditGrades; VIX;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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