Related Securities and Equity Market Quality: The Case of CDS

Abstract

We document that the emergence of markets for single-name credit default swap (CDS) contracts adversely affects equity market quality. The finding that firms with traded CDS contracts on their debt have less liquid equity and less efficient stock prices is robust across a variety of market quality measures. We analyze the potential mechanisms driving this result and find evidence consistent with negative trader-driven information spillovers that result from the introduction of CDS. These spillovers greatly outweigh the potentially positive effects associated with completing markets (i.e., CDS markets increase hedging opportunities) when firms and their equity markets are “bad” states. In “good” states, we find some evidence that CDS markets can be beneficial.