The Information Content of Cross-Market Deviations in Option Prices and Credit Default Swap Spreads

Abstract

Cross-market deviations in equity put option prices and credit default swap spreads are temporal and revert to their usual level shortly after they occur, on average within about one week. The process of reversion involves predictable and economically significant changes also in the equity values of the reference firm, thus empirically supporting the theoretical linkage of the three markets. Cross-market deviations occur for firms with high information uncertainty and are not created equally. Firms with unusually more expensive credit than equity insurance are likely to experience informed trading in their credit insurance contract. However, we attribute instances of unusually expensive equity insurance to belief heterogeneity.

Keywords: credit equity market integration, equity return predictability, capital structure arbitrage

JEL Classification: G11, G12, G13, G14, D8