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

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