Credit default swap (CDS) returns are driven by equity returns, which indicates that informed traders are more active in the equity market versus the CDS market partially because of transaction costs. Significant news events, such as earnings announcements, tend to lead to more rapid responses in CDS returns than do non-news days.
Credit default swap (CDS) contracts permit investors to trade credit protection, but some regulators have restricted the use of the contracts to limit destabilizing speculative moves. Standard financial theory suggests that securities related to the same underlying asset are affected by the same fundamental shocks. But more nuanced theory indicates that informed traders may prefer one security market over another because of price impact, leverage, and transaction costs. The authors examine whether equity returns lead CDS returns (or vice versa) by looking at relative information content from the view of market selection by informed traders.
How Is This Research Useful to Practitioners?
The authors note that stock returns predict credit protection returns for time frames of up to several weeks. In contrast, credit protection returns do not adequately predict future equity returns. These findings indicate that informed traders are more active in the equity market whereas liquidity traders participate in the CDS market.
Bid–ask spreads that are sufficiently large in the CDS market deter informed traders from switching to the CDS market despite the prevalence of uninformed traders in that market. Consequently, the CDS bid–ask spreads (in percentage terms) are higher for firms with better credit ratings because they are more sensitive to information about firm value relative to lower-rated firms.
CDS spreads do not adjust quickly to equity return data, and credit protection return predictability using equity returns comes with a time lag of five trading days in daily specifications and a time lag of four weeks in weekly specifications. In trying to explain the long time lag in predictability, the authors find that CDS market prices respond more slowly to news in the equity market for firms with a low number of quotes in the CDS market (proxy for high transaction costs) and that the CDS market responds more quickly to equity returns that are larger in absolute terms. CDS returns respond more rapidly to stock returns right after regular earnings announcements, which is when both equity and CDS traders pay attention.
How Did the Authors Conduct This Research?
To examine cross-market predictability, the authors use daily and weekly data of CDS contracts from 2001 to 2007 for 783 firms. Data for five-year CDSs are sourced from Markit Group Limited and Datastream. Equity market data, accounting data, and Standard & Poor’s credit ratings are sourced from CRSP and Compustat.
To determine whether equity returns predict CDS returns or vice versa, the authors regress daily and weekly credit protection returns on contemporaneous and lagged equity returns. The same regressions are run for equity returns. The regressions are run separately for firms rated A and above, for firms rated BBB, and then for firms rated BB or below.
The authors then look at the predictive ability of equity returns in predicting CDS returns for large equity returns and negative equity returns because CDS features could imply that CDS spreads react more quickly to the two factors. They find that there is no difference in adjustment speed for CDS spreads attributable to negative equity returns.
Next, the authors test whether transaction costs play a role in keeping informed investors in the equity market and not the CDS market. CDS returns should adjust more slowly to equity returns if there is a low depth of CDS contracts (proxy for high transaction costs). They should adjust more quickly if the equity return is large in absolute value because large informational shifts in the equity market should lead to profitable trades in CDSs unless transaction costs are high.
Another possible explanation for the slow movement in CDS spreads to information in equity returns may be inattention; hence the authors study cross-responses between CDS returns and equity returns during earnings announcement days and non-announcement days.
The authors’ finding of a time lag between moves in equity prices and CDS prices should be taken into account for equity funds that hedge using CDSs because there may be some basis mismatch in hedging. Although there seems to be the drawback of transaction costs that preclude most informed traders from trading CDSs on the back of equity-moving news, more liquid CDS indexes may be a worthwhile avenue to use to act on news.