Advertisement

Journal of Economics and Finance

, Volume 43, Issue 1, pp 1–26 | Cite as

Relation between Credit Default Swap Spreads and Stock Prices: A Non-linear Perspective

  • Miroslav MateevEmail author
  • Elena Marinova
Article

Abstract

In this study, we investigate the relation between credit risk, as implied in the credit default swaps (CDS), and market prices of Markit iTraxx Europe index companies. To test the hypothesis of co-integration between CDS and stock prices, we apply linear and non-linear models that allow for structural breaks. Using Johansen trace test of cointegration for a set of 109 pairs of CDS and stock prices of the companies included in the index, over the period of January 2012 to January 2016, we find that at the 10% level of significance, the null hypothesis of no cointegration is rejected for 26 pairs. We extend our analysis by allowing for a one-time structural break with unknown timing. Using alternative cointegration tests, we find that CDS and stock prices are cointegrated. More specifically, there are 47 companies in our sample for which CDS spreads and stock prices are cointegrated at the 10% level of significance. The existence of a long-run relation between CDS and stock prices of the European investment-grade companies is evidence for a possible transmission of shocks between the two segments of the financial market – the credit market (via CDS) and the stock market.

Keywords

Credit default swap iTraxx index Cointegration Structural breaks Threshold 

JEL classification

C58 G10 G12 

Supplementary material

12197_2017_9423_MOESM1_ESM.docx (79 kb)
ESM 1 (DOCX 78 kb)

References

  1. Andersen T, Bondarenko O (2007) Construction and Interpretation of Model-Free Implied Volatility. NBER Working Paper No. 13449Google Scholar
  2. Balke N, Fomby T (1997) Threshold Cointegration. Research Paper. Federal Reserve Bank of Dallas. Available at http://dallasfed.org/assets/documents/research/papers/1992/wp9209.pdf
  3. Black F, Cox J (1976) Valuing Corporate Securities: Some Effects of Bond Indenture Provisions. J Financ 31(2):351–367CrossRefGoogle Scholar
  4. Black F, Scholes M (1973) The Pricing of Options and Corporate Liabilities. J Polit Econ 81(3):637–654CrossRefGoogle Scholar
  5. Blair BJ, Poon S-H, Taylor SJ (2001) Forecasting S&P 100 Volatility: The Incremental Information Content of Implied Volatilities and High-Frequency Index Returns. J Econ 105:5–26CrossRefGoogle Scholar
  6. Blanco R, Brenan S, Marsh I (2005) An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps. J Financ 60(5):2255–2281CrossRefGoogle Scholar
  7. Chan-Lau J A, Kim YS (2004) Equity Prices, Credit Default Swaps, and Bond Spreads in Emerging Markets, IMF Working Paper, No. WP/04/27Google Scholar
  8. Collin-Dufresne P, Goldstein RS, Martin JS (2001) The Determinants of Credit Spread Changes. J Financ 56(6):2177–2208CrossRefGoogle Scholar
  9. Corzo M T, Gomez-Biscarri J, Lazcano L (2012) The Co-Movement of Sovereign Credit Default Swaps and Bonds, and Stock Markets in Europe. Available at SSRN: http://ssrn.com/abstract=2000057 or doi:10.2139/ssrn.2000057
  10. Crouch P, Marsh, I (2005) Arbitrage Relationships and Price Discovery in the Autos Sector of the Credit Market. Working Paper Series, Cass Business SchoolGoogle Scholar
  11. Delianedis G, Geske R (2001) The Components of Corporate Credit Spreads: Default, Recovery, Tax, Jumps, Liquidity, and Market Factors. Working paper 22–01, UCLA Anderson, School of ManagementGoogle Scholar
  12. Demeterfi K, Derman E, Kamal M, Zhou J (1999) More Than You Ever Wanted to Know About Volatility Swaps. Goldman Sachs Quantitative Strategies Research NotesGoogle Scholar
  13. Du L, Masli A, Meschke F (2013) The Effect of Credit Default Swaps on the Pricing of Audit Services. Working Paper Series, School of Business, The University of KansasGoogle Scholar
  14. Duffi D, Singleton K (1999) Modelling Term Structures of Defaultable Bonds. Rev Financ Stud 12(4):687–720CrossRefGoogle Scholar
  15. Dwyer GP (2015) The Johansen Tests for Cointegration. Available at http://www.jerrydwyer.com/pdf/Clemson/Cointegration.pdf. Accessed July 24, 2016
  16. Enders W (2004) Applied Econometric Time Series (Second ed.). John Wiley & Sons, HobokenGoogle Scholar
  17. Eyssell T, Fund H-G, Zhang G (2013) Determinants and Price Discovery of China Sovereign Credit Default Swaps. China Econ Rev 24(C):1–15CrossRefGoogle Scholar
  18. Fabozzi FJ, Cheng X, Chen R-R (2007) Exploring the Components of Credit Risk in Credit Default Swaps. Finance Research Letters 4:10–18CrossRefGoogle Scholar
  19. Figuerola-Ferretti I, Paraskevopoulos I (2010) Pairing Market Risk and Credit Risk, Working paper. Carlos III University, MadridGoogle Scholar
  20. Fontana A, Scheicher M (2010) An Analysis of Euro Area Sovereign CDS and Their Relation with Government Bonds. European Central Bank, Working Paper Series, No. 1271Google Scholar
  21. Forte S, Lovreta L (2008) Credit Risk Discovery in the Stock and CDS Market: Who, When and Why Leads? Available at http://www.finance-innovation.org/risk09/work/1166347.pdf
  22. Fung H-G, Sierra G, Yau J, Zhang, G (2008) Are the U.S. Stock Market and Credit Default Swap Market Related? Evidence from the CDX Indices. Available at http://www.umsl.edu/divisions/business/files/pdfs/Zhang_Publication/CDS%20JAI%20Final%20FSYZ.pdf
  23. Granger C (1981) Some Properties of Time Series Data and Their Use in Econometric Model Specification. J Econ 16(1):121–130CrossRefGoogle Scholar
  24. Greatrex CA (2009) Credit Default Swap Market Determinants. The Journal of Fixed Income 18:18–32CrossRefGoogle Scholar
  25. Gregory A, Hansen B (1996) Residual-Based Tests for Cointegration in Models with Regime Shifts. Journal of Econometrics 70: 99–126, available at http://www.ssc.wisc.edu/~bhansen/papers/joe_96.pdf. Accessed 24 Jul 2016
  26. Grouard M H, Lévy S, Lubochinsky C (2003) Stock Market Volatility: From Empirical Data to Their Interpretation. Working Paper, FSR, Banque de FranceGoogle Scholar
  27. Hansen B (1999) Threshold Effects in Non-Dynamic Panels: Estimation, Testing, and Inference. Journal of Econometrics 93: 345–368. Available at ftp://ftp.soc.uoc.gr/students/aslanidis/My%20documents/papers/Hansen%20(1999).pdf. Accessed 24 Jul 2016
  28. Hansen B, Seo B (2002) Testing for Two-Regime Threshold Cointegration in Vector Error-Correction Models. Journal of Econometrics 110: 293–318. Available at http://www.ssc.wisc.edu/~bhansen/papers/joe_02.pdf. Accessed 24 Jul 2016
  29. Hull J, White A (2000) Valuing Credit Default Swaps I: No counterparty Default Risk. J Deriv 8(1):29–40CrossRefGoogle Scholar
  30. Jacobs M, Karagozoglu A, Peluso, C (2010) Measuring Credit Risk: CDS Spreads vs. Credit Ratings. Available at http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.455.8017&rep=rep1&type=pdf. Accessed 19 Aug 2016
  31. Jarrow R, Turnbull S (1995) Pricing Derivatives on Financial Securities Subject to Default Risk. J Financ 50(1):53–85CrossRefGoogle Scholar
  32. Jiang G, Tian Y (2003) Model-Free Implied Volatility and Its Information Content. Available at http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.194.7470&rep=rep1&type=pdf. Accessed 19 Aug 2016
  33. Johansen S (1998) Statistical Analysis of Cointegration Vectors. J Econ Dyn Control 12(2–3):231–254Google Scholar
  34. Kapar B, Olmo J (2011) The Determinants of Credit Default Swap Spreads in the Presence of Structural Breaks and Counterparty Risk. Working Paper 2011/02, Department of Economics, City University, London
  35. Lee V, Fang V, Lin E (2007) Volatility Linkages and Spillovers in Stock and Bond Markets: Some International Evidence. Journal of International Finance and Economics 7(1):1–10Google Scholar
  36. Litterman R, Iben T (1991) Corporate Bond Valuation and the Term Structure of Credit Spreads. J Portf Manag 17(3):52–64CrossRefGoogle Scholar
  37. Lo M, Zivot E (2001) Threshold Cointegration and Nonlinear Adjustment to the Law of One Price. Macroecon Dyn 5:533–576Google Scholar
  38. Longstaff FA, Mithal S, Neis E (2005) Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from The Credit Default Swap Market. J Financ 60(5):2213–2253CrossRefGoogle Scholar
  39. Longstaff FA, Pan J, Pedersen LH, Singleton KJ (2007) How Sovereign is Sovereign Credit Risk? Unpublished Working Paper, UCLA Anderson School, MIT Sloan School, NYU Stern School, and Stanford Graduate School of BusinessGoogle Scholar
  40. Merton R (1974) On the Pricing of Corporate Debt: The Risk Structure of Interest Rates. J Financ 29(2):449–470Google Scholar
  41. Mayhew S, Stivers C (2003) Stock Return Dynamics, Option Volume, and the Information Content of Implied Volatility. J Futur Mark 23(7):615–646CrossRefGoogle Scholar
  42. Ngene G (2012) Momentum, Nonlinear Price Discovery and Asymmetric Spillover: Sovereign Credit Risk and Equity Markets of Emerging Countries. Available at http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.455.8225&rep=rep1&type=pdf. Accessed 19 Aug 2016
  43. Ngene G, Hassan K (2012) Momentum, Nonlinearity in Cointegration and Price Discovery: Evidence from Sovereign CDS and Equity Markets of Emerging Countries. Available at http://cbt2.nsuok.edu/kwok/conference/submissions/swfa2013_submission_200.pdf
  44. Norden L, Weber M (2009) The Co-movement of Credit Default Swap, Bond and Stock Markets: An Empirical Analysis. Eur Financ Manag 15(3):477–691CrossRefGoogle Scholar
  45. Otker-Robe I, Podpiera J (2010) The Fundamental Determinants of Credit Default Risk for European Large Complex Financial Institutions. IMF Working Paper, WP /10/153Google Scholar
  46. Pan J, Singleton JK (2007) Default and Recovery Implicit in the Term Structure of Sovereign CDS Spreads. J Financ 63:2345–2384CrossRefGoogle Scholar
  47. Perron P (1989) The Great Crash, The Oil Price Shock, and The Unit Root Hypothesis. Econometrica 57:361–1401CrossRefGoogle Scholar
  48. Rapsomanikis G, Hallam D (2006) Threshold Cointegration in The Sugarethanol-Oil Price System in Brazil: Evidence from Nonlinear Vector Error Correction Models. Working Paper No. 22, FAO Commodity and Trade Policy ResearchGoogle Scholar
  49. Schueler M (2001) CDS Basis Trading. Working Paper, JP Morgan Credit Derivatives MarketingGoogle Scholar
  50. Schneider PG, Sögner L, Veza T (2007) The Economic Role of Jumps and Recovery Rates in the Market for Corporate Default Risk. Available at SSRN: http://ssrn.com/abstract=961341
  51. Stigler M (2013) Threshold Cointegration: Overview and Implementation in R. 2010, revision 2013. Available at https://cran.r-project.org/web/packages/tsDyn/vignettes/ThCointOverview.pdf. Accessed 24 Jul 2016
  52. Tang DY, Yan H (2007) Liquidity, Liquidity Spillover and Credit Default Swap Spreads. AFA Annual Meeting Paper, ChicagoGoogle Scholar
  53. Wang H, Zhou H, Zhou Y (2011) Credit Default Swap Spreads and Variance Risk Premia. Finance and Economics Discussion Series. Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.Google Scholar
  54. Zhu H (2004) An Empirical Comparison of Credit Spreads Between the Bond Market and the Credit Default Swap Market. BIS Working Paper No. 160Google Scholar
  55. Zivot E, Andrews D (1992) Further Evidence on the Great Crash, the Oil-Price Shock, and the Unit-Root Hypothesis. J Bus Econ Stat 10(3):251–270Google Scholar
  56. Markit iTraxx Europe series 24. Available at https://www.markit.com/NewsInformation/NewsAnnouncementsFile?CMSID=6eeeb28203e94f3f83c83d2a58609ab3. Accessed 17 Aug 2016

Copyright information

© Springer Science+Business Media, LLC, part of Springer Nature 2017

Authors and Affiliations

  1. 1.American University in the EmiratesDubaiUnited Arab Emirates
  2. 2.EM Capital Consult Ltd.SofiaBulgaria

Personalised recommendations