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Stock Prices and Stock Return Volatilities Implied by the Credit Market

Hans Byström

No 2013:25, Working Papers from Lund University, Department of Economics

Abstract: In this paper we compare equity- and credit investors’ opinions on the price formation in the equity market. More exactly, we invert the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for the firms in the DJIA index. The creditimplied stock prices often deviate significantly from actual stock prices over the longer term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA index. In an attempt to demonstrate potential applications of credit-implied stock prices we construct simple “capital structure arbitrage” trading strategies based on past credit-implied prices. Our 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. We demonstrate how an alternative credit-based “fear gauge”, comparable to the VIX index but emanating from the credit market, can be constructed using the credit-implied volatilities. We call this implied volatility index the Credit-Implied Volatility Index (CIVX) index. Finally, a plot of the entire term-structure of implied volatilities demonstrates a distinct maturity volatility skew.

Keywords: credit default swaps; implied volatility; implied stock prices; CreditGrades; VIX (search for similar items in EconPapers)
JEL-codes: G10 (search for similar items in EconPapers)
Pages: 41 pages
Date: 2013-08-14, Revised 2014-02-14
New Economics Papers: this item is included in nep-fmk and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Forthcoming as Byström, Hans, 'Stock Prices and Stock Return Volatilities Implied by the Credit Market' in Journal of Fixed Income.

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Persistent link: https://EconPapers.repec.org/RePEc:hhs:lunewp:2013_025

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