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

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