Empirical evidence on theoretical relationship between corporate credit default swaps and bond spreads

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School of Business | Master's thesis
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Date
2013
Major/Subject
Finance
Rahoitus
Mcode
Degree programme
Language
en
Pages
88
Series
Abstract
The purpose of this thesis is to study traded corporate credit risk in the CDS and bond markets. As credit risk is being traded in both bond market and the CDS market, to avoid arbitrage, a close relation between the bond yield spread and the CDS spread must be satisfied. As bond and CDS spreads measure the credit risk of the underlying entity, their reaction to material public information related to the same reference entity should be identical. This thesis studies this equilibrium relationship. The data set consists of corporate entities on the iTraxx Europe 125 series 14. The final sample includes 35 entities. The full period under review spans from May, 1, 2006 to March 31, 2012. Divided by the collapse of Lehman Brothers, the full period is further splitted into two sub-periods: the pre-crisis period and the crisis period. All data used in this study is obtained from Bloomberg Markets Terminal. To test the hypotheses, cointegration tests, vector error correction models and least squares regression methods are used. The yields of corporate bonds used are interpolated synthetically in order to match them with constant maturity of CDS products. Findings of the study show that a long-term equilibrium relationship exists between CDS and bond markets. The finding is not as clear-cut as concluded by previous research. More robust evidence was detected regarding risk-free reference rates used by investors. The Euro swap rate proved to be a substantially more appropriate measure of risk-free rate than the German government bond yield. The CDS market is leading the bond market in price discovery. The contribution of the CDS market to price discovery increases during the crisis period. CDS prices are more sensitive to changes in firm-specific equity prices. Bond yields are more sensitive to changes in macro variables.
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Keywords
credit default swap, bond spread, basis spread, price discovery
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