Stock Prices and Stock Return Volatilities Implied
by the Credit Market

Abstract

In this article, the author compares equity and credit investors’ opinions on price formation in the equity market. More exactly, he inverts the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for companies in the DJIA index. The credit-implied stock prices often deviate significantly from actual stock prices over the long term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA. In an attempt to demonstrate potential applications of credit-implied stock prices, the author constructs simple “capital structure arbitrage” trading strategies based on past credit-implied prices. These strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. The author demonstrates how an alternative credit-based “fear gauge,” comparable to the CBOE VIX but emanating from the credit market, can be constructed using the credit-implied volatilities. He calls this implied volatility index the Credit-Implied Volatility Index (CIVX). Finally, a plot of the entire term structure of implied volatilities demonstrates a distinct maturity volatility skew.

TOPICS: Security analysis and valuation, credit default swaps