Do the stock and CDS markets price credit risk equally in the long-run?

Lidija Lovreta and Zorica Mladenović

The European Journal of Finance, 2018, vol. 24, issue 17, 1699-1726

Abstract: In this paper, we examine the existence and stability of the long-run equilibrium relation between the price of credit risk in the stock and CDS markets for a sample of non-financial iTraxx Europe companies during the 2004–2017 period. We show that standard cointegration tests with no breaks frequently fail to detect cointegration. Once we formally account for the breaks in the cointegrating vector, we are able to detect cointegration over the entire sample period for the vast majority of the companies considered. An application of these results to CDS-equity trading shows that the profitability of traditional trading strategies crucially depends on the presence of cointegration and on the stability of the cointegrating vector. Finally, we find that CDS illiquidity factors decrease the likelihood of the stock and CDS market cointegration.

Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:taf:eurjfi:v:24:y:2018:i:17:p:1699-1726

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DOI: 10.1080/1351847X.2018.1501402

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