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Department of Economics, Lund University Working Papers, Department of Economics, Lund University

No 2005:24:
Credit Default Swaps and Equity Prices: The Itraxx CDS Index Market

Hans N. E. Byström ()

Abstract: In this paper we provide some early evidence of a link between the iTraxx credit default swap (CDS) index market and the stock market. To our knowledge this is the first paper studying this relationship. Knowledge about the link between stock prices, stock return volatilities and CDS spreads is important not only for risk managers using credit default swaps for hedging purposes, but also to anyone trying to profit from arbitrage possibilities in the CDS market. For a sample of European sectoral iTraxx CDS indexes, a correlation study reveals a tendency for iTraxx CDS spreads to narrow when stock prices rise and vice versa. Furthermore, there is some evidence of firm-specific information being embedded into stock prices before it is embedded into CDS spreads. Stock price volatility is also found to be significantly correlated with CDS spreads and the spreads are found to increase (decrease) with increasing (decreasing) stock price volatilities. Finally, we find significant positive autocorrelation in the iTraxx market.

Keywords: credit default swap index; stock market index; stock return volatility; (follow links to similar papers)

JEL-Codes: C20; G33; (follow links to similar papers)

14 pages, March 11, 2005, Revised May 15, 2005

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This paper is published as:
Byström, Hans N. E., (2008), 'Credit Default Swaps and Equity Prices: The iTraxx CDS Index Market' in Wagner, Niklas (ed.) Credit Risk - Models, Derivatives, and Management, Financial Mathematics Series, Vol. 6, pages 69-83, Chapman & Hall.



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