A Markov Switching Cointegration Analysis of the CDS‐Bond Basis Puzzle

45 Pages Posted: 30 Oct 2019

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University - Department of Finance

Francesco Melloni

Bocconi University

Manuela Pedio

Bocconi University - CAREFIN - Centre for Applied Research in Finance

Date Written: October 2019

Abstract

We investigate the long-run equilibrium relationship between credit default swap (CDS) premia and bond spreads for 65 U.S. corporate entities and 6 major banks over the period April 2011 – February 2018. Standard regression methods reveal that in 40 out of 71 entities, the two series fail to be cointegrated, which is puzzling because it represents a violation of the efficient market hypothesis. Differently from the previous literature, we estimate a Markov switching vector error correction model to capture the fact that regimes may be characterize the adjustment mechanism and the short-term dynamics between the spread series. We use this framework to investigate how the two markets contribute to the price discovery of credit risk. We find that there are many entities that switch between a regime where the adjustment to the long-run cointegrating relationship does not take place and a regime where one between the CDS or the bond markets leads the price discovery. Finally, we investigate whether the industry or other firm characteristics, such as the rating, the leverage, and the capital structure, may be relevant to determine which of the two markets is leads in the price discovery process.

Keywords: credit risk, credit default swap, bond spreads, Markov switching, vector error correction models, price discovery

JEL Classification: C32, E52, E43

Suggested Citation

Guidolin, Massimo and Melloni, Francesco and Pedio, Manuela, A Markov Switching Cointegration Analysis of the CDS‐Bond Basis Puzzle (October 2019). BAFFI CAREFIN Centre Research Paper No. 2019-121. Available at SSRN: https://ssrn.com/abstract=3477322

Massimo Guidolin (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Francesco Melloni

Bocconi University ( email )

Via Sarfatti, 25
Milan, MI 20136
Italy

Manuela Pedio

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Sarfatti, 25
Milan, 20136
Italy

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