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

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