The Credit Risk Information Dynamics Between the Cds and Equity Markets

Download or read book The Credit Risk Information Dynamics Between the Cds and Equity Markets written by Vincent Xiang and published by . This book was released on 2012 with total page 330 pages. Available in PDF, EPUB and Kindle. Book excerpt: An information link exists between the credit default swap (CDS) and equity markets. The CDS spread is an observable price of a reference firm's credit risk. The same credit risk information is also reflected in its equity price. According to the structural credit risk pricing approach, equity is analogous to a call option written on firm assets, with the face value of the debt as the strike price. Accordingly, the probability of non-exercise equals the probability of default. Any information that affects a firm's creditworthiness affects the value of this call option and hence the stock price.This thesis examines the credit risk information dynamics between the CDS and equity markets. Unlike existing studies, we do not model the interaction between the change of CDS spread and stock return. This is because stock returns also reflect non-credit-related information. Instead, we utilise the CreditGrades model, which belongs to the structural credit risk pricing approach, to extract the implied credit default spread (ICDS) from a firm's equity price. The pairwise CDS spread and ICDS thus represent price of credit risk from the CDS and equity markets, respectively.We propose a new approach to calibrate the CreditGrades model to extract the ICDS. First, we make a less arbitrary assumption regarding unobservable parameters that describe the stochastic recovery process of the firm. Second, we calibrate unobservable parameters on a more frequent basis. Third, we recalibrate model parameters to incorporate newly released accounting figures, since the recovery process is determined by a firm's capital structure fundamental. We document strong evidence that our calibration approach generates more accurate ICDS estimates than those used by previous studies. The more accurate ICDS estimates facilitate a cleaner study of credit risk information flow between the CDS and equity markets.We analyse the nature of information linkage between the CDS and equity markets for a sample of 174 U.S. investment-grade firms. We document strong cointegration between the CDS spread and ICDS, suggesting a long-run credit risk pricing equilibrium between the two markets. Using Gonzalo and Granger (1995) and Hasbrouck (1995) measures, we sort firms into five categories of credit risk price discovery. When forward-shifting the estimation window, we uncover an interesting transmigration pattern. From January 2005 to June 2007, the CDS market influenced price discovery for 92 firms. From January 2006 to June 2008, with the onset of the global financial crisis (GFC), that number increased to 159. As we move away from the height of the GFC, the number of CDS-influenced firms diminishes but remains high compared to the pre-GFC period. Using CDS spreads as trading signals, a conditional portfolio strategy that updates the list of CDS-influenced firms produces a significant alpha against Fama-French factors. It also outperforms buy-and-hold, momentum, and dividend yield strategies.Finally, we propose a new trading algorithm to implement capital structure arbitrage, a convergent-type strategy that exploits mispricing between the CDS and equity markets. Our trading algorithm incorporates both long-run credit risk pricing equilibrium and short-run price discovery process between the two markets. Using our trading algorithm, the arbitrageur avoids the risk of non-convergence and of incurring substantial losses. We confirm that most of the trading profits are generated by conditioning the strategy on firms for which the CDS market dominates the price discovery process. Despite the fact that our trading sample covers the entire GFC, the conditional trading strategy produces a Sharpe ratio that is comparable to that of other fixed income arbitrage strategies.