The relationship between equity prices and credit default swap spreads: An empirical analysis

Ida Buus & Charlotte Renneberg J. Nielsen

Student thesis: Master thesis

Abstract

This thesis analyses the relationship between equity prices and credit default spreads (CDS). The CDS is an OTC contract that provides insurance against the risk of default by a particular company A CDS reflects the credit risk and this credit risk is also present in equity prices as credit risk influence the value of a firm. The relationship between CDS spreads and equity prices is interesting to examine since the nature and direction of this relationship can be used when making economic models, issuing debt and planning arbitrage strategies and the CDS’ played a role in the depth and increase of the crisis that started in 2008. Furthermore due to the young age of the CDS market the available research on the subject is limited and our study will contribute by being the most extensive as far as we know. We analyse the relationship between equity prices and credit default spreads during the period 2nd January 2004 to 1st May 2009 for 265 firms present in S&P 500 in 2002. We examine the daily lead-lag relationship in a vector autoregressive model (VAR) or in the case of cointegration in a vector error correction model (VECM). Additionally we examine the Spearman Rank correlation, Granger Causality test & Granger-Gonzalo measure. First, we find that equity prices and CDS spreads are negatively correlated. Second, that equity prices influence CDS spreads and not the other way around. Third, that the relationship is not affected by including exogenous variables in the model. Fourth, that the strength of the relationship increases the higher the credit risk. Fifth, we find that for some sectors the relationship becomes more pronounced the higher the leverage in the sector. We examine how an increase in credit risk influence the relationship by splitting our data into before and after the beginning of the crisis, in rating, and quartiles. We find that the influence of equity prices on CDS spreads is stronger in the period after the beginning of the crisis than before. This indicates that the relationship between CDS spreads and equity prices is stronger under deteriorating market conditions. Furthermore we examine how the credit rating of the underlying entity affects the relationship. We do this by splitting our data in investment grade and high yield. The influence of equity prices on CDS spreads is stronger for the high yield model than the investment grade model. This indicates that the relationship between CDS spreads and equity prices is stronger the lower the credit rating of the underlying entity. At last we examine how the size of the CDS spread effects the relationship. We do this by splitting our data into quartiles. We split the data for index, before and after the beginning of the crisis, high yield, and investment grade. We find that when comparing the quartiles against each otherthe influence of equity prices on CDS spreads is strongest for quartile 4, second strongest for quartile 3, third strongest for quartile 2 and least strongest for quartile 1. Moreover when comparing the quartile models with their respective overall index we find that quartile 3 and 4 are stronger models than the overall model except for the models for high yield and investment grade. The overall conclusion is that there is a negative relationship between CDS spreads and equity prices and that equity prices lead CDS spreads

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2009
Number of pages114