Market Vs Model Credit Default Swap Spreads: Mind the Gap!

Abstract

This paper provides important empirical insights into the relation between equity and credit variables. For this purpose, we compare market and model credit default swaps (CDS) spreads for a sample of obligors over the period 2002-2005, where model spreads are obtained from a popular structural model based on equity market variables. We find that, in general, model spreads display a significant correlation with market spreads. However, the gap between the two widens substantially when equity volatility is high. We investigate various determinants of this gap, in order to highlight potential shortcomings of the model. Furthermore, we test to what extent model spreads predict market spreads. Finally, we analyze the convergence properties of the gap between empirical and theoretical spreads.

Keywords: Equity volatility, Credit spreads, Structural models , Trading strategies

JEL Classification: G21, C22, G10