On the relationship between sovereign CDS and equity markets : evidence from the European debt crisis

Abstract

This paper examines the price equilibrium and dynamic relationship between credit default swap (CDS) and equity markets for European sovereign issuers in a time period which encompasses the ongoing European debt crisis. In line with previous research, our results suggest that the markets are inversely related, wherein the strength of the association is related to the underlying obligors’ credit quality. Further, we reject the presence of a price equilibrium relationship in the time period under study, indicating that capital structure arbitrage strategies may be difficult to implement. Based on vector autoregressive (VAR) models and Granger causality, our overall results suggest that the CDS market has the leading role in all countries associated with high CDS spreads. Moreover, the stock market seems to contribute the most to price revelation in countries further away from default. This corroborates the view of informed players trading in the credit derivatives market.