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

• Author: Santiago Forte,Lidija Lovreta
• DOI: http://doi.org/10.1111/j.1468-036X.2013.12020.x
• Published date: 01 June 2015
• Date: 01 June 2015

Time‐Varying 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, E‐08172 Sant Cugat del Vallès,

Barcelona, Spain

E-mail: santiago.forte@esade.edu

Lidija Lovreta

CUNEF, Calle Serrano Anguita 8, E‐28004 Madrid, Spain

E-mail: lidija.lovreta@cunef.edu

Abstract

We analyse the dynamic relationship between the stock and the CDS market during

the period 2002–2008. We document that the stock market’s informational

dominance reported in previous studies holds only in times of financial crisis.

During tranquil times, the CDS market’s 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 financial activities and, by definition, should be implicitly

or explicitly reflected 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 (MAEC‐AECID) (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, 430–461

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 efficiently reflects new information

regarding credit risk? In an attempt to solve this riddle, recent empirical work has focused

primarily on finding 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 cross‐sectional 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 (Odders‐White 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 findings,

two natural questions emerge. Are the relative market contributions to credit risk

discovery time‐varying? If so, what factors influence 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 non‐crisis periods. The

analysis is based on data on CDS spreads and stock market implied credit spreads (ICS)

for 92 non‐financial European companies tracked during the period 2002–2008,

which covers: the dot‐com crisis (year 2002), the posterior period of quiet markets

(2003–mid‐2007), and the sub‐prime crisis (mid‐2007–2008).

1

Our main results could be summarised as follows. First, we corroborate the conclusions

in previous empirical tests based on data from the dot‐com 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

non‐crisis periods. More specifically, we find supporting evidence for the leading role of

the stock market during the dot‐com and sub‐prime crises, but not during the in‐between

non‐crisis period. In quiet times, the CDS market’s contribution to price discovery proves

to be equal or higher than that of the stock market. This finding is particularly relevant

considering the current debate on the role of the credit derivatives market in the formation

of credit risk prices before the sub‐prime 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 finding,

1

The analysis could also benefit 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 final sample (see Blanco et al., 2005;

Zhu, 2006; Norden and Weber, 2009; Forte and Peña, 2009).

© 2013 John Wiley & Sons Ltd

Time‐Varying 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

discovery.

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 time‐varying relationship between CDS

spreads and ICS, and studies the relative informational dominance of the stock and CDS

markets in crisis vs. non‐crisis periods. Section 5 examines the specific factors underlying

credit risk discovery in a time‐varying 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 inter‐dealer 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 find significant 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 reflect market sentiment rather than indications. Consequently, we are

confident that our CDS data provides a fair representation of the informational content of

the trading activity in the CDS market.

2

The initial data set contains 1,641,326 intra‐day 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 reflects the

steady development of the CDS market activity during the time period considered.

In this study we consider only the most liquid euro‐denominated 5‐year 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 finance 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 financialdata. 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.

2

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