What Drives the Price Convergence between Credit Default Swap and Put Option: New Evidence

53 Pages Posted: 16 Jul 2018 Last revised: 13 Apr 2021

See all articles by Ka Kei Chan

Ka Kei Chan

Brunel University London

Olga Kolokolova

University of Manchester - Alliance Manchester Business School

Ming-Tsung Lin

University of Essex

Ser-Huang Poon

Alliance Manchester Business School, University of Manchester; Alan Turing Institute

Date Written: April 13, 2021

Abstract

Although credit default swaps (CDSs) and deep out-of-the-money put (DOOMP) options can both be used for credit protection, these markets are not perfectly integrated and the implied hazard rates differ across these markets. The differences depend on the relative deviation of consensus rating-based hazard rate curves in the two markets, and a residual component, arising due to the individual market frictions. Using CDS and put option data from July 2012 to April 2016, we show that both components diminish over time, but their convergence is asynchronous. A trading strategy based on a joint signal from the curve and residual differences delivers a positive average return and significantly outperforms a conventional trading approach that relies on the absolute differences between CDS- and DOOMP-implied hazard rates.

Keywords: Credit Default Swap (CDS), Deep Out-of-the-Money Put Option, Market Segmentation, Convergence, Trading Strategy

JEL Classification: G11, G17, G24

Suggested Citation

Chan, Ka Kei and Kolokolova, Olga and Lin, Ming-Tsung and Poon, Ser-Huang, What Drives the Price Convergence between Credit Default Swap and Put Option: New Evidence (April 13, 2021). Available at SSRN: https://ssrn.com/abstract=3188892 or http://dx.doi.org/10.2139/ssrn.3188892

Ka Kei Chan

Brunel University London ( email )

Kingston Lane
Uxbridge, Middlesex UB8 3PH
United Kingdom

Olga Kolokolova

University of Manchester - Alliance Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom
+441613062081 (Phone)

Ming-Tsung Lin (Contact Author)

University of Essex ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom

HOME PAGE: http://https://www.essex.ac.uk/people/linmi48001/ming-tsung-lin

Ser-Huang Poon

Alliance Manchester Business School, University of Manchester ( email )

Alliance Manchester Business School
Booth Street West
Manchester, Manchester M15 6PB
United Kingdom
+44 161 275 4031 (Phone)
+44 161 275 4023 (Fax)

HOME PAGE: http://www.manchester.ac.uk/research/Ser-huang.poon/

Alan Turing Institute ( email )

British Library, 96 Euston Road
London, NW12DB
United Kingdom

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