Volatility Discovery: Can the CDS Market Beat the Equity Options Market?

Abstract

In this study, we derive a CDS implied equity volatility index from highly liquid one-year contracts in the Eurozone, and for the inclusive period 2008-2014. We analyze the relationship between this volatility index and the VSTOXX 12M within a fractionally cointegrated vector autoregressive (FCVAR) model. Our results confirm a stationary long-run equilibrium relationship between the two volatility indices in which the CDS implied index plays the leading role.

Keywords: CDS market; options market; implied volatility; fractional cointegration; volatility discovery

JEL Classification: G13; G14