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

51 Pages Posted: 16 Jul 2018 Last revised: 19 Apr 2019

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 17, 2019

Abstract

Credit default swaps (CDSs) and deep out-of-the-money put (DOOMP) options can both be used as a credit protection instrument. However, partial market segmentation results in deviations between firm hazard rates implied by these contracts. These deviations are driven by a systematic component--difference in the consensus rating-based levels of hazard rates in the two markets, and an idiosyncratic component, arising due to market frictions. We show that both components diminish over time, but their convergence is asynchronous. A trading strategy based on a joint signal of both systematic and idiosyncratic deviations delivers a positive arbitrage return after transaction costs and outperforms a conventional approach on trading on the absolute deviations between CDS- and DOOMP-implied hazard rates.

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

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 17, 2019). 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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