Do the stock and CDS markets price credit risk equally in the long-run?

In this paper, we examine the existence and stability of the long-run equilibrium relation between the price of credit risk in the stock and CDS markets for a sample of non-financial iTraxx Europe companies during the 2004-2017 period. We show that standard cointegration tests with no breaks frequen...

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Bibliographic Details
Published inThe European journal of finance Vol. 24; no. 17; pp. 1699 - 1726
Main Authors Lovreta, Lidija, Mladenović, Zorica
Format Journal Article
LanguageEnglish
Published London Routledge 22.11.2018
Taylor & Francis LLC
Subjects
cointegration
Cointegration analysis
Credit default swaps
Credit risk
Economic models
Markets
Profitability
structural breaks
Trading
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Summary:In this paper, we examine the existence and stability of the long-run equilibrium relation between the price of credit risk in the stock and CDS markets for a sample of non-financial iTraxx Europe companies during the 2004-2017 period. We show that standard cointegration tests with no breaks frequently fail to detect cointegration. Once we formally account for the breaks in the cointegrating vector, we are able to detect cointegration over the entire sample period for the vast majority of the companies considered. An application of these results to CDS-equity trading shows that the profitability of traditional trading strategies crucially depends on the presence of cointegration and on the stability of the cointegrating vector. Finally, we find that CDS illiquidity factors decrease the likelihood of the stock and CDS market cointegration.
ISSN:1351-847X
1466-4364
DOI:10.1080/1351847X.2018.1501402