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What Moves the Correlation between the Equity and Credit Default Swap Markets?

Zilong Liu, Xiaoling Pu and Xinlei Zhao
The Journal of Fixed Income Fall 2015, 25 (2) 72-87; DOI: https://doi.org/10.3905/jfi.2015.25.2.072
Zilong Liu
is an instructor of finance at Kent State University in Kent, OH.
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  • For correspondence: zilong728@gmail.com
Xiaoling Pu
is an associate professor of finance at Kent State University in Kent, OH.
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  • For correspondence: xpu2@kent.edu
Xinlei Zhao
is a senior financial economist in the Credit Risk Analysis Division of the Office of the Comptroller of the Currency at the U.S. Department of the Treasury in Washington, DC.
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  • For correspondence: xinlei.zhao@occ.treas.gov
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Abstract

We document substantial correlation dynamics between equity returns and CDS spread changes at the firm level, which is critical for cross-market hedging and arbitrage strategies. Using the implied cost of capital approach, we decompose the unexpected equity returns into cash flow and discount rate news and examine the impact of the shocks on the correlations. We find that discount rate news explains the majority fraction. At longer horizons and in periods when cash flow news is more negatively related with CDS spread changes, however, the cross-market integration is stronger. In addition, firms with more cash flow news exhibit stronger correlations between equity returns and credit spread changes, and the structural model can explain more variations of credit spread changes in these firms.

TOPICS: Security analysis and valuation, credit default swaps, quantitative methods

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The Journal of Fixed Income: 25 (2)
The Journal of Fixed Income
Vol. 25, Issue 2
Fall 2015
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What Moves the Correlation between the Equity and Credit Default Swap Markets?
Zilong Liu, Xiaoling Pu, Xinlei Zhao
The Journal of Fixed Income Sep 2015, 25 (2) 72-87; DOI: 10.3905/jfi.2015.25.2.072

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What Moves the Correlation between the Equity and Credit Default Swap Markets?
Zilong Liu, Xiaoling Pu, Xinlei Zhao
The Journal of Fixed Income Sep 2015, 25 (2) 72-87; DOI: 10.3905/jfi.2015.25.2.072
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  • Article
    • Abstract
    • DATA AND SUMMARY STATISTICS
    • EQUITY RETURN DECOMPOSITION
    • CORRELATION DYNAMICS IN TIME SERIES
    • CORRELATION DYNAMICS IN CROSS SECTIONS
    • CONCLUSIONS
    • ENDNOTES
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