An Empirical Analysis of the Dynamic Relationship between Investment Grade Bonds and Credit Default Swaps

Abstract

We analyse the behaviour of credit default swaps (CDS) for a sample of firms and find support for the theoretical equivalence of CDS prices and credit spreads. When this is violated we suggest the CDS price can be viewed as an upper bound on the price of credit risk, while the spread provides a lower bound. We show that the CDS market is the main forum for credit risk price discovery and that CDS prices are better integrated with firm-specific variables in the short-run. Both markets equally reflect these factors in the long-run, and this is primarily brought about by bond market adjustment.

Keywords: Credit derivatives, price discovery

JEL Classification: G14