Scandinavian Working Papers in Economics

Working Papers,
Lund University, Department of Economics

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

Hans N. E. Byström ()
Additional contact information
Hans N. E. Byström: Department of Economics, Lund University, Postal: Department of Economics, School of Economics and Management, Lund University, Box 7082, S-220 07 Lund, Sweden

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

JEL-codes: C20; G33

14 pages, First version: March 11, 2005. Revised: May 15, 2005.

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