The Empirical Relationship between CDS Prices and Bond Yields after the Financial Crisis

Marko Celic

Student thesis: Master thesis


This paper contributes to the literature analysing the empirical relationship between CDS spreads and bond yields. In theory, the prices of these assets are linked through an arbitrage relationship. The paper employs a sample of 32 companies covering the period from the beginning of 2010 until the end of 2011 obtained from the publicly available data sources Bloomberg and Datastream. It then creates artificial 5-year bond yields by linear interpolation and estimates the basis spread, which should be zero if the arbitrage relationship holds perfectly. Subsequently, several econometric concepts are employed to investigate the relationship between the series, including cointegration analysis, Granger-causality, half-life of deviations and price discovery measures. Several findings emerge. In contrast to previous researchers, this paper finds that yields on government bonds serve as better proxy for the risk-free rate instead of the swap rates. Increased overall risk in the financial sector after the financial crisis and especially in European institutions during the European sovereign debt crisis is a potential explanation for this result. In line with previous research, the paper finds that the arbitrage relationship holds reasonably well on a medium- to long-term perspective. In the short-term however, the spreads can move away significantly from their equilibrium values. Additionally, there are a few exceptional cases which constantly show large non-zero basis spreads and constitute mainly financial institutions. Furthermore, several differences emerge when grouping companies by rating, country and distinguishing between financial and non-financial companies. Additionally, in line with previous research, CDS markets seem to lead bond markets. However, this relationship weakens for lower graded entities and reverses during times of crisis. Two theories might explain this finding. First, trading in investment-grade bonds might increase during times of crisis, such that bond prices provide more information. Second, increased counterparty risk inherent in CDS might disturb CDS spreads such that the information value of CDS prices is decreased. From a technical point of view, this paper argues for employing the Schwarz Bayesian Criterion in contrast to the widely used Akaike Information Criterion for cointegration analysis, because the latter tends to have superior properties in this context. Furthermore, weekly instead of daily observations seem to be more appropriate for cointegration analysis, because of less microstructural noise.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
Publication date2012
Number of pages93