Working Papers, Department of Economics, Lund University
Stock Prices and Stock Return Volatilities Implied by the Credit Market
Abstract: In this paper we compare equity- and credit investors’
opinions on the price formation in the equity market. More exactly, we
invert the CreditGrades model in order to back out credit-implied stock
prices and stock return volatilities from credit default swap spreads for
the firms in the DJIA index. The creditimplied stock prices often deviate
significantly from actual stock prices over the longer term. Meanwhile,
their day-to-day movements are significantly correlated with actual stock
returns for most firms in the DJIA index. In an attempt to demonstrate
potential applications of credit-implied stock prices we construct simple
“capital structure arbitrage” trading strategies based on past
credit-implied prices. Our strategies only require the buying and selling
of stocks and differ from traditional cross-capital structure strategies by
being suitable for retail investors and other investors without access to
the credit derivatives market. The credit-implied volatilities, in turn,
behave rather similarly to observed stock market volatilities but without
any ghost effects. We demonstrate how an alternative credit-based “fear
gauge”, comparable to the VIX index but emanating from the credit market,
can be constructed using the credit-implied volatilities. We call this
implied volatility index the Credit-Implied Volatility Index (CIVX) index.
Finally, a plot of the entire term-structure of implied volatilities
demonstrates a distinct maturity volatility skew.
Keywords: credit default swaps; implied volatility; implied stock prices; CreditGrades; VIX; (follow links to similar papers)
JEL-Codes: G10; (follow links to similar papers)
41 pages, August 14, 2013, Revised September 13, 2014
- This paper is forthcoming as:
Byström, Hans, 'Stock Prices and Stock Return Volatilities Implied by the Credit Market', Journal of Fixed Income.
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