Revisiting the Credit–Equity Power Relationship

Abstract

The credit–equity power relationship is an empirical parameterization of credit default swap (CDS) spreads by stock prices that is characterized by its credit–equity elasticity parameter and that is popular among practitioners involved in capital structure arbitrage quantitative strategies. This article provides a theoretical foundation for the credit–equity elasticity involving the financial leverage of the company. After underscoring the weaknesses of a calibrating approach relying exclusively on econometrics, the article highlights the practical relevance of this fundamental result in terms of credit–equity calibration.

TOPICS: Fixed income and structured finance, quantitative methods