Dynamics and Determinants of Credit Risk Discovery: Evidence from CDS and Stock Markets

Abstract

This paper investigates the dynamics and drivers of credit risk discovery between stock and CDS markets in the US. Our research is distinguished from the existing literature in three aspects: 1) We employ an improved method to measure the information share; 2) we discover new drivers of credit risk discovery; and 3) we assess the impact of central clearing counterparty (CCP) on the CDS market. By using the generalized information share (GIS) by Lien and Shrestha (2014), we address the issue that the CDS and stock prices do not have one-to-one cointegration relation. The empirical results support the use of GIS instead of more conventional measures. We also find that eliminating transitory price components increases the information share of the CDS market in the earlier period of the sample. The economic condition and funding cost turn out to affect the information share of the CDS market negatively. Another interesting finding is that the CDS of investment grade firms possess higher information shares compared to speculative grade firms. Finally, CCP seems to reduce the information share of CDS, which suggests that the CDS market is driven largely by insider trading.

Keywords: credit risk discovery, generalized information share, determinants of credit risk discovery

JEL Classification: G12, G14, G28