How Integrated Are Credit and Equity Markets? Evidence From Index Options

Pierre Collin-Dufresne, Benjamin Junge and Anders B. Trolle
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Pierre Collin-Dufresne: Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute; National Bureau of Economic Research (NBER)
Benjamin Junge: Ecole Polytechnique Fédérale de Lausanne; Ecole Polytechnique Fédérale de Lausanne
Anders B. Trolle: Copenhagen Business School - Department of Finance

No 20-65, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: In recent years, a liquid market for options on a broad credit default swap index (CDX) has developed. We study the extent to which these options are priced consistently with options on a broad equity index (SPX). We consider a rich structural credit risk model in which firm assets follow a jump-diffusion process with idiosyncratic and systematic risk, and we derive analytical expressions for CDX and SPX options. Calibrating the model, we find that it captures many aspects of the joint dynamics of CDX and SPX options. However, it cannot reconcile the relative levels of option implied volatilities, suggesting that credit and equity markets are not fully integrated. A strategy of selling CDX options yields significantly higher average excess returns and Sharpe ratios than selling SPX options.

Keywords: Credit Risk; Cdx; Cdx Options; Spx; Spx Options; Structural Models (search for similar items in EconPapers)
JEL-codes: G12 G13 (search for similar items in EconPapers)
Pages: 78 pages
Date: 2020-07
New Economics Papers: this item is included in nep-cfn
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2065

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