Time‐Varying Credit Risk Discovery in the Stock and CDS Markets: Evidence from Quiet and Crisis Times

Published date01 June 2015
Date01 June 2015
TimeVarying Credit Risk Discovery in
the Stock and CDS Markets: Evidence
from Quiet and Crisis Times
Santiago Forte
ESADE Business School Ramon Llull University, Av. Torreblanca 59, E08172 Sant Cugat del Vallès,
Barcelona, Spain
E-mail: santiago.forte@esade.edu
Lidija Lovreta
CUNEF, Calle Serrano Anguita 8, E28004 Madrid, Spain
E-mail: lidija.lovreta@cunef.edu
We analyse the dynamic relationship between the stock and the CDS market during
the period 20022008. We document that the stock markets informational
dominance reported in previous studies holds only in times of nancial crisis.
During tranquil times, the CDS markets contribution to price discovery is equal or
higher than that of the stock market. Moreover, the credit risk level of the company
has a positive effect on the information share of its stocks beyond the effect of the
overall state of the economy. We show that these conclusions do not contradict the
argument of insider trading in credit derivatives.
Keywords: credit risk, credit default swap market, stock market, price discovery
JEL classification: G12, G14
1. Introduction
Credit risk concerns almost all nancial activities and, by denition, should be implicitly
or explicitly reected through market prices of credit sensitive claims, such as credit
We acknowledge financial support from Fundación UCEIF and Banco Santander; Banco
Sabadell (Santiago Forte); and Ministerio de Asuntos Exteriores y de Cooperación, y
Agencia Española de Cooperación Internacional (MAECAECID) (Lidija Lovreta). We also
thank Viral Acharya, Carmen Ansotegui, Mascia Bedendo, Vivien Brunel, John Doukas,
Ariadna Dumitrescu, Sergio Mayordomo, Zorica Mladenovic´, José Olmo, Pavle Petrovic´,
Antonio Rubia, Giovanni Urga and an anonymous referee for their helpful suggestions. The
usual disclaimers apply. Correspondence: Lidija Lovreta.
European Financial Management, Vol. 21, No. 3, 2015, 430461
doi: 10.1111/j.1468-036X.2013.12020.x
© 2013 John Wiley & Sons Ltd
default swaps (CDS), bonds and stocks. These assets are traded in structurally different
markets, implying probable differences in the relative speed with which respective
markets respond to changes in underlying credit conditions. Accordingly, the key issue
arises: which of these markets more rapidly and more efciently reects new information
regarding credit risk? In an attempt to solve this riddle, recent empirical work has focused
primarily on nding the market that leads the credit risk price discovery process. This
literature suggests that the stock market tends to lead the CDS and bond markets (Norden
and Weber, 2009; Forte and Peña, 2009) and that the CDS market tends to lead the bond
market (Longstaff et al., 2003; Blanco et al., 2005; Zhu, 2006; Norden and Weber, 2009;
Forte and Peña, 2009).
This empirical evidence has typically been built upon crosssectional analysis. Several
studies suggest, however, that factors underlying credit risk discovery are, in fact,
dynamic. There is a well documented positive relationship between the credit quality of a
particular company and the liquidity of its stocks (OddersWhite and Ready, 2006), bonds
(Longstaff et al., 2005; Bühler and Trapp, 2009) and CDS (Bühler and Trapp, 2009).
Results in Acharya and Johnson (2007) and Norden (2011) are consistent with the use of
private information in the CDS market in the presence of negative credit shocks. In
addition, Forte and Peña (2009) provide preliminary evidence that the informational
content of CDS, bond and stock markets, does change over time. In light of these ndings,
two natural questions emerge. Are the relative market contributions to credit risk
discovery timevarying? If so, what factors inuence the relative informational
dominance of competing markets? The precise aim of this paper is to provide further
insight into these basic questions, with a particular focus on the stock and CDS markets
and their relative informational dominance in crisis versus noncrisis periods. The
analysis is based on data on CDS spreads and stock market implied credit spreads (ICS)
for 92 nonnancial European companies tracked during the period 20022008,
which covers: the dotcom crisis (year 2002), the posterior period of quiet markets
(2003mid2007), and the subprime crisis (mid20072008).
Our main results could be summarised as follows. First, we corroborate the conclusions
in previous empirical tests based on data from the dotcom crisis (Norden and
Weber, 2009; Forte and Peña, 2009), but at the same time we point out that these
conclusions should not be extrapolated to other arbitrary time periods and, in particular, to
noncrisis periods. More specically, we nd supporting evidence for the leading role of
the stock market during the dotcom and subprime crises, but not during the inbetween
noncrisis period. In quiet times, the CDS markets contribution to price discovery proves
to be equal or higher than that of the stock market. This nding is particularly relevant
considering the current debate on the role of the credit derivatives market in the formation
of credit risk prices before the subprime crisis (Stulz, 2010). Second, we document a
positive effect of the credit risk level of the company on the information share of its stocks
above and beyond the effect of the general state of the economy. We interpret this result as
a natural consequence of the higher sensitivity of equity prices to credit risk related
information under worsening credit conditions (Avramov et al., 2009). This nding,
The analysis could also benet from considering the bond market in addition to the stock and
CDS markets. This extension, however, would probably be achieved at the cost of a
substantial reduction in the number of companies in the nal sample (see Blanco et al., 2005;
Zhu, 2006; Norden and Weber, 2009; Forte and Peña, 2009).
© 2013 John Wiley & Sons Ltd
TimeVarying Credit Risk Discovery 431
however, complements rather than contradicts the argument of insider trading in credit
derivatives (Acharya and Johnson, 2007; Norden, 2011). As the third main contribution of
the paper we provide additional evidence of a positive relationship between the presence
of severe credit deterioration shocks and the probability of the CDS market leading price
The remainder of the paper is structured as follows. Section 2 describes the CDS and
ICS database. Section 3 presents and applies the methodology for credit risk discovery
analysis. Section 4 provides evidence of a timevarying relationship between CDS
spreads and ICS, and studies the relative informational dominance of the stock and CDS
markets in crisis vs. noncrisis periods. Section 5 examines the specic factors underlying
credit risk discovery in a timevarying context. Section 6 provides robustness checks.
Finally, Section 7 summarises our main conclusions.
2. Data
2.1. CDS spreads
Data on CDS spreads is provided by GFI, an interdealer broker in credit derivatives. The
election of the CDS database is not irrelevant, particularly in light of recent evidence by
Mayordomo et al. (2011b) who nd signicant differences in the informational content of
CDS spreads coming from different data providers. Contrary to other databases, the GFI
data refer to actual executable and executed market prices where dealers commit capital
and, as such, they reect market sentiment rather than indications. Consequently, we are
condent that our CDS data provides a fair representation of the informational content of
the trading activity in the CDS market.
The initial data set contains 1,641,326 intraday quote and trade entries for 643
European reference entities. The data comprise information on the seniority of the
reference issue, currency and maturity of the contract; however, there is no trade direction
indicator, and no information on size. The time period spans from January 2002 to
December 2008. As indicated in Figure 1, the number of available quote and trade entries
is not evenly distributed across time but is increasing gradually till 2007. This reects the
steady development of the CDS market activity during the time period considered.
In this study we consider only the most liquid eurodenominated 5year maturity
contracts, andcontracts drawn on senior unsecured debt.Given the purpose of our analysis,
several additional criteria have been applied. First, sovereigns and companies that are not
publicly traded are excludedfrom the sample; companies in the banking and nance sector
are also excluded due to their different capital structure. Second, because market
capitalisation and other inputs required for the estimation of ICS are collected from
Datastream, severalcompanies are further excluded due to the lack of an appropriate match
or the required nancialdata. Third, with the aim of ensuring the availabilityof CDS spread
observations on a daily basis we focus on reference entities with relatively active CDS
contracts. For that purpose,all the companies with 0 trades in any of the considered years,
and companies with quotes and trades availablefor less than 5% of the trading days in any
of the considered years are also excluded from the sample.
GFI data are just corrected for potential errors using both experienced data analysts and
statistical cleaning algorithms. For a comparison of GFI data with other databases see
Mayordomo et al. (2011a).
© 2013 John Wiley & Sons Ltd
432 Santiago Forte and Lidija Lovreta

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