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1 August 2014 CFA Institute Journal Review

Information Content in CDS Spreads for Equity Returns (Digest Summary)

  1. Louis A. Lemos

During economic turmoil, there is significant information flow from the equity market to the credit default swap market for investment-grade firms and vice versa for non-investment-grade firms. In addition, when investigating behavior surrounding the announcement day, the authors find evidence of a significant negative response from one-day-ahead returns to credit protection returns on the credit announcement day.

What’s Inside?

The authors study the information flow between the equity and credit default swap (CDS) markets, with emphasis on the information content of credit protection returns. They use daily data—both contemporaneous and lagged. Further analysis is conducted to check the response of the two markets around the credit rating announcement day to examine the information content in the changing credit condition.

How Is This Research Useful to Practitioners?

This research is an important contribution to the current literature on price discovery and comovement of the CDS and equity markets.

The results indicate that equity returns can predict credit protection returns at a horizon of up to five days, especially under tumultuous market conditions. Credit protection returns do not seem to have a leading role for investment-grade firms. The authors interpret these results as evidence of the independence of equity and CDS markets for entities with a high credit rating, particularly when arbitrage opportunities are infrequent.

Credit protection returns are more sensitive to lagged equity returns when credit weakening has been identified in the CDS market. This finding suggests that although the information in lagged credit protection returns cannot predict the magnitude of future equity returns, it does provide extra information for the equity returns based on the condition of the credit market.

The authors do not discover any significant response from credit returns to contemporaneous equity returns on the credit rating announcement day, nor is there a significant response of one-day-ahead credit protection returns to equity returns. It is notable that credit protection returns on the announcement day have a significant response to lagged equity returns for non-investment-grade firms. This outcome indicates that for non-investment-grade issuers, CDS markets and equity markets are more narrowly linked, especially when the broad market is in turmoil and firm credit quality worsens.

There is both a statistically and economically significant response from one-day-ahead equity returns to credit protection returns on credit announcement days during normal market periods. The authors thus posit that there may be informed trading in the CDS market for firms with high credit ratings and, therefore, that CDS contracts with high-rated entities are more likely to be exploited by informed traders.

How Did the Authors Conduct This Research?

The authors begin by providing a brief introduction to the CDS market and describing the datasets used in the analysis. The data consist of five-year US CDS levels on senior, unsecured debt obtained from Bloomberg. Daily equity market data, quarterly accounting data, and monthly credit ratings for Standard & Poor’s are collected from CRSP and Compustat. A total of 252 US nonfinancial and nonpublic administration firms are examined from 1 July 2004 to 31 August 2010. The complete sample period is divided into two periods (before and after the end of 2007) to allow a determination of the global financial crisis effect.

Looking at each firm, the authors examine the response of credit protection returns and equity returns. A regression model is specified to capture the contemporaneous response of credit protection returns and equity returns and the response of credit protection returns and lagged equity returns. The authors estimate the same model for investment-grade and non-investment-grade firms across three sample periods and repeat the analysis by adding one-period-lagged credit protection returns and one-period-lagged equity returns to the model to capture market conditions and whether extra information can be obtained from the CDS market. Next, they present the response in the other direction—specifically, the response of equity returns from credit protection returns.

The authors conclude their research by studying the response of the two markets around the credit announcement day to investigate the information content of credit protection returns further.

Abstractor’s Viewpoint

The authors’ research is an important contribution to the existing literature on the information flow between the equity and CDS markets. The research should be of particular interest for sophisticated investors who are arbitraging across the equity and CDS markets and for members of the academic community who have an interest in the important topic of information spillover in asset pricing.

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