How Integrated Are Credit and Equity Markets? Evidence from Index Options

In recent years, a liquid market for options on a broad credit index (CDX) has developed. We study the extent to which these options are priced consistently with options on a broad equity index (SPX). We consider a rich structural credit risk model in which firm assets follow a jump-diffusion process with idiosyncratic and systematic risk, and we derive analytical expressions for CDX and SPX options. Calibrating the model, we find that it captures many aspects of the joint dynamics of CDX and SPX options. However, it cannot reconcile the relative levels of option prices, suggesting that credit and equity markets are not fully integrated. A strategy of selling CDX call options against SPX put options yields statistically significant average excess returns and high Sharpe ratios.