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A. Raymond Elmahdaoui and Charles Dugas June 15, 2009

Abstract We look at the economical signiﬁcance of the correlation between variation in Credit Default Swaps (CDS) spreads and the variation of the underlying stock one day ahead. We use diﬀerent trading strategies directly on the stocks using information in the CDS market to show that this correlation is indeed economically signiﬁcant. In fact, we show that variations in the CDS spreads can be used proﬁtably as a signal to trade the underlying stock, if the credit rating is low.

1

Introduction

In a perfectly eﬃcient market, no publicly available information can be used to predict future asset prices since all that information is already taken into account in today’s prices. The eﬃciency of ﬁnancial markets is still a subject of debate (for example, see [5]). It is a well known stylized fact that asset prices have very little autocorrelation (except maybe in lag one due to nonsynchronous or thin trading). This suggests some level of eﬃciency in ﬁnancial markets (usually referred to as weak form eﬃciency) since it implies that historical prices of the asset do not contain information about future prices (see [3] and [7]). However, it is still possible that asset prices can be predicted using information other than historical prices. In this article, we use CDS spread changes as a signal that the underlying stock price is more likely to go up or down. CDS is a credit risk derivative which was growing more and more popular until the recent crisis. This derivative is a contract in which company A (the seller) accepts to pay company B (the buyer) a certain amount of money if company C defaults on its debts (for example because of bankruptcy or restructuring). In exchange, company B pays every year a premium to company A (called the CDS spread). Many 1

We give some ideas for further research in this ﬁeld in section 6. In particular. the strategy consists.e. 2 . When the CDS spread does not go down. Mathematically. So. Finally. in this case. 2 Strategies In this section. we look at the CDS spread. The ﬁrst strategy tries to predict rises in the stock price each time the CDS spread goes down by buying the stock and selling it the day after. Finally. we present the strategies we analyze for that purpose and the diﬀerent methods used to test the proﬁtability of those strategies. we discuss a few strategies that use the correlation found in [4] to make a proﬁt by predicting the behavior of the underlying stock of a CDS. They argue that such correlation might be due to informed traders taking advantage of the high leverage present in the derivatives market. [6] and [8]). we assume our money is invested at the LIBOR overnight rate. the variation from today to tomorrow). especially for ﬁrms that have low credit ratings and ﬁrms with high CDS volatility. We then describe precisely the data on which the strategies are tested in section 4 and we show the numerical results in section 5. In sections 2 and 3. we conclude in Section 7. [4] has found a statistical (negative) correlation between variation in CDS spreads and variation in the stock prices one day ahead. of buying the stock today and selling it tomorrow. the third strategy uses CDS spreads ﬂuctuations to decide how to perform portfolio allocation between diﬀerent stocks. [4] tells us that the variation of the stock price might be positive one-day ahead (i. If the spread went down today compared to yesterday. 2. An in-depth analysis of insider trading in credit derivatives can be found in [1].articles have studied the relationship between the CDS market and the stock market (see for example [2].1 Predicting Ascending Stock Prices In the ﬁrst strategy that we consider. The second strategy tries to predict price drops in the stock when the CDS spread goes up by selling the stock and buying it back the day after. [4]. it means that if the stock price at time t is given by Pt .The goal of this article is to see if that correlation can be used economically by developing strategies that consistently use the variation of CDS spreads to decide when to buy or sell the underlying stock.

(2) Evidently. To compute the total return with transaction costs. buy the stock back tomorrow and ﬁnally sell it the day after. If transaction costs are not accounted for. The annualized return can then be obtained as AN = 252 × RN /N (3) if we consider that there are 252 trading days in a year (which we assume in this article). Lt is the LIBOR overnight rate for day t and It has value one if ∆Yt is negative and has value zero if it is not the case. we introduce the variable Ct which has value one only if It = It−1 and has value zero elsewhere. One simple idea to proﬁt from that knowledge would be to buy the stock in the beginning. then the buyer can buy the stock today. when 3 . sell the stock tomorrow. the correlation found in [4] suggests that the underlying stock price might go down the next day. If. The idea is that if the CDS spread goes up. transaction costs can be accounted for in RN with the formula N RN = t=1 It rt − Ct c + (1 − It )Lt . transaction costs are accounted for. equation (1) is the special case of (2) with c = 0. this is the same thing as buying the stock today and selling it two days from now. then one can simply deduct that rate from rt in each term in the above formula. 2. This formula does not take into account transaction costs. We only have to be careful about one thing : if the derivatives value goes down today and again tomorrow. however. Then.2 Predicting Descending Stock Prices This strategy is very similar to the previous one. With this notation. If transaction costs can be expressed as a ratio c of the stock price (and suppose that c includes both transactions needed to buy and then sell the stock). We can also make a variant of this strategy by specifying a band β ≥ 0 so that the buy signal It has value one if and only if ∆Yt < −β . (1) where rt = log (Pt ) − log (Pt−1 ) is the stock return.the total return RN of this strategy at time N will be N RN = t=1 It rt + (1 − It )Lt . the second option is evidently more cost-eﬃcient.

t . The total return from this strategy is simply N M RN = t=1 i=1 ωit ri. we sell all the stocks. 2. In other words. In fact. The total return becomes N M RN = t=1 i=1 ωit ri. The day after. every day t we look at the number of ﬁrms who had a negative variation (or a negative variation 4 . two diﬀerent weighting schemes will be explored in this article. We then do the same process every day.t − Cit c. we can also take into account transaction costs by creating a variable Cit analogous to the variable Ct deﬁned as |ωit − ωi. So.3 Portfolio Management This strategy uses the CDS variations of all ﬁrms today to decide in which stocks to invest for the next day. For this strategy. we did not describe precisely how to choose the values of ωit knowing the CDS spreads variation. the investor sells the stock the same day and buys it back the day after. as in previous sections. For a company i on day t.the CDS spread goes up. We can also consider diﬀerent values of β ≥ 0 so that It has value one if and only if ∆Yt > β instead. where c. we look at all the ﬁrms (or a subset of ﬁrms) and compute de CDS variation for each one. we decide what proportion of our capital to invest in each ﬁrm. The ﬁrst will be with equal-weighted investments. Of course. is the transaction cost expressed as a rate.1 becomes N RN = t=1 −It rt − Ct c + It Lt where It now has value one if and only if ∆Yt is positive. where M is the total number of companies (we can count LIBOR as a company if we want to be able to invest on this rate) and M i=1 ωit = 1 for all t. At that moment. The formula of section 2. We can also suppose that the investor can proﬁt from the LIBOR rate when he sells the stock.t−1 | (the change in the weight allowed to this particular stock). we denote by ωit the weight we place on that company’s stock price return.

In most cases (including our own) determining the p-value would be too computationally intensive. As for the previous variant. t − M j =1 ∆Yij t where the ij sum over all companies that had a negative variation on their CDS spread that day.).1 Monte Carlo p-value The ﬁrst ratio is the Monte Carlo p-value. if Mt = 0. 3 Analyzing the Performance of a Strategy Computing returns from our strategies will not be enough to decide if using CDS information really is beneﬁcial for investing in stocks. we suggest two ratios that we can compute for all strategies. etc. Reprising our notation ∆Yit for the variation in CDS Yit − Yi(t−1) for company i. We would like to compare our strategies to other strategies using other transaction signals. where N is the number of transaction days. in our strategy predicting ascending stock prices. 3. we will always compare our results to the LIBOR rates and to the annual variation of the S&P index. we invest on the LIBOR rate instead. since every day there can be a transaction signal (or not). The p-value in that case is the proportion of strategies having better returns than the one we analyze. economical situation. If Mt = 0. We would like to compare the strategy using CDS spreads to the 2N possible strategies. If Mt = 0. For this reason. All strategies in this article use transaction signals (given by the variation of the CDS spreads) that tell us when to buy and sell the stocks. we invest all our capital on the overnight LIBOR rate for that day. Also. For a given ﬁrm.exceeding a preﬁxed band). we ﬁx ωit = 1/Mt for those ﬁrms. The workaround we will use is to estimate 5 . on each day there are two choices : buying a stock (and selling it the day after) or investing the money at the LIBOR rate. Another variant that will be explored is with weights proportional to the absolute value of the variation in CDS. there are 2N possibilities for such strategies. we can deﬁne ωit for companies that had a negative variation in CDS as ωit = −∆Yit . For example. Suppose that number is Mt . Abnormally high returns (or abnormally low ones) could be due to other factors (high volatility of the asset.

In other words.2 Sharpe Ratio Another tool used to analyze the returns will be the Sharpe ratio. This can be easily adapted for the strategy predicting descending stock prices. 4 Data For all the computations in this article. market (NYSE) that had 1. 2. It is useful to compare diﬀerent investments that might not have the same risk (i. This p-value represents the probability that an investor following a series of randomly generated buy signals (or sell signals) does better than an investor following a strategy in which the signals are given by the CDS spreads. We selected all companies in the U. 3. their S&P rating for January 2004 recorded in Compustat. Obviously.S. a closing price for their stock recorded in CRSP for February 5. a 5-year senior CDS spread recorded in Datastream for February 5. the same volatility). a high return with a high volatility has a lesser Sharpe ratio than the same return with a lower volatility. 3.60%) and σ is the volatility (standard deviation) of the daily returns. 6 . we randomly choose if we invest in each company every day. the lower the p-value the better. The goal of the Sharpe ratio is to normalize the returns so that the excess return is expressed as a multiple of the volatility. 2004. 2008.e. r is the risk-free rate (we will take the average LIBOR rate during the period considered : 3. σ where AN is the annualized return. For the portfolio management. This will give us an idea of how well our strategy works against other strategies on the same possible stock returns. the data (Stock prices and CDS spreads) is taken between February 5. given by the formula AN − r . 2004. 2004 and December 31.the p-value by randomly generating a ﬁxed number of such strategies (say 1000) and compute the p-value on those strategies only.

this means that our strategy is a little bit more signiﬁcant for ﬁrms rated B. Their p-values suggest they are almost always signiﬁcant at the 5% level. 5. We look at these subsets of our ﬁrms to see if there is indeed any diﬀerence between those ﬁrms and others.) with no transaction costs and a band of 4 bp. Those results seem much more impressive. a return of 19. 5 Results on subsets of ﬁrms According to [4].2. the returns 7 . we use overnight LIBOR rates (in U.1 for details).In total. especially for low-rated ﬁrms. the data used for this study is taken from February 2004 to December 2008 and might be inﬂuenced by the current economical crisis. If the CDS contained no information at all about the Stock prices one day later. resp. This analysis is also true for the descending strategy. Table 1 shows the average annual return of ascending and descending strategies (sections 2.to B+ have dropped (on average) 21. Indeed. As we can see.1 and 2. In this context. For example. However.08% is less impressive. Table 2 shows the results for the portfolio management strategies of section 2. Although the credit rating does not seem to inﬂuence the p-value in any obvious way.S.to B+ than for other ﬁrms. the p-value for the ascending strategy is a bit lower for low rated ﬁrms.1 Credit Rating We ﬁrst separate ﬁrms according to their S&P credit rating. Keep in mind that during that period. the correlation between CDS spread variation and stock price variation one day ahead should be stronger among ﬁrms that have low credit rating and ﬁrms that have high CDS spread volatility. Also.. we found 321 companies responding to those criteria. The number in parentheses is the average estimated p-value (see section 3. The table also shows how p-values are important for this analysis since returns themselves are much higher in the descending strategy than in the ascending one.. a strategy that bets on price drops will always fare better than a strategy that bets on the rise of the stock price. the S&P 500 has dropped 4. dollar) as given by the British Bankers’ Association. this diﬀerence could be due to characteristics in the market (or in the stocks themselves) that have nothing to do with our strategy using CDS.3.54% annually and the stocks of the 18 ﬁrms rated B.60% annually would seem very good while a return of 6. In our case. we would expect the p-value to be around 50%.44% annually.

table 3 shows the Sharpe ratios corresponding to the results in table 2.29) themselves are much higher for ﬁrms rated B.36) 11.51) 1.36) 6.83% (0. the proportional weights improve the returns (the only exception is group 7).60% (0.38% (0.08% (0. So.69% (0. especially when taking into account the average drop of those stock in this period.to AAA 22 -0.42% (0. we see that for almost all groups.33) 6. We can also combine both criteria and take only ﬁrms that are in the ﬁrst group and are rated B. we see that the ﬁrst 4 groups have a p-value of 0 on both variants of the strategy.20% (0. as if the strategies themselves had not much inﬂuence on the returns obtained.62% (0. 5.and BB.to BB 26 -3. although for the p-values.52) BBB 57 0. Most p-values seem to be around 50%. on which the strategy does not work so well (especially for A-rated ﬁrms).63) A 39 -0.to B+. Of interest in this table are the results for A-rated ﬁrms and for ﬁrms rated BB. The same can be said of the returns in table 5.64) A34 0.18% (0.2 CDS spread volatility We then separate the ﬁrms into ten groups by their CDS spread volatility. there are 15 ﬁrms left.16% (0.52% (0.53) BBB+ 47 -0.62) A+ 24 0.Table 1: Comparison of Strategies for Diﬀerent Credit Ratings Credit Rating Number of ﬁrms Ascending Descending AA.. Also. Finally.59% (0.92% (0.44) 3. If we do that.60% (0.29% (0.39) 12.39) 1.49) BB.53) BBB33 1.13% (0.26% (0.46) B.84% (0.to B+ 18 6. the CDS seems to have an inﬂuence over the p-value.1.91% (0. the CDS volatility does not seem to have a signiﬁcant eﬀect on the eﬃciency of both strategies.38) 3.to B+.. The annual return of both strategies are shown in table 4 with their respective p-value. Also.39) 5.53) BB+ 21 0. taking weights proportional to the CDS variation is not always an improvement over taking equal weights. We can see that there is a tendency for the ratio to be higher as the credit rating is lower (with a few exceptions).24) 19. 8 .53% (0. Contrary to the credit ratings in section 5.

52% (<1e-05) BB+ 15.00) A5.98% (<1e-05) Table 3: Comparison of Portfolio Management Strategies’ Sharpe Ratios for Diﬀerent Credit Ratings Credit Rating Equally Weighted Proportional to CDS Variation AA.19% (<1e-05) A+ 11.to BB -18.49% (0.79% (<1e-05) 18.10 1.80% (<1e-05) BBB+ 4.00) -21.84 BBB+ 0.to B+ 9.61 A -12.98% (<1e-05) 19.to B+ 29.to BB -8.84% (<1e-05) BBB8.62 5.21% (<1e-05) BB.90 A1.51% (0.86 -6.66% (<1e-05) A -31.87 4.53 2.97 B.03 A+ 3.67% (<1e-05) 7.46% (<1e-05) BBB 1.61% (1.32% (<1e-05) 19.22) -20.45% (<1e-05) 10.Table 2: Comparison of Portfolio Management Strategies for Diﬀerent Credit Ratings Credit Rating Equally Weighted Proportional to CDS Variation AA.15 4.09 5.16% (<1e-05) 3.49 9 .52 -1.99 BBB -0.30) B.80% (<1e-05) 13.88 BB.01 BB+ 6.to AAA -4.64% (0.02 0.05) -0.to AAA -10.32 BBB2.79% (1.53 -7.

3 Eﬀects of the transaction costs and the choice of the band One possible problem with the aforementioned strategies is that they might demand a high number of transactions.43) 1.53) 4.01% (0.41) 16.51% (0.52% (0.51) -1. We can see in this table that a band of 4 bp yields better returns than the others.30) -0.52% (0.38) 13.53) 4. for diﬀerent values. This is due to the fact that. If we take transaction costs into account. if the band is too large. Keep in mind that all results obtained before were without transaction costs and with a band of 4 bp. The results are those of the portfolio management with equal weights among the 18 ﬁrms which are rated between B.43) -0.43) Volatilities Descending 10. For that value. To study the eﬀect of both band and transaction costs on the returns.33% (0.and B+. On the other hand. but the Sharpe ratio is a bit lower).15% (0.91% (0. in the case of the ascending strategy.31% (0. we will miss opportunities in the stock market.40) 3. 5.07% (0.90% (0.Table 4: Comparison of Strategies for CDS volatility group Number of ﬁrms 1 (most volatile) 31 2 32 3 32 4 32 5 33 6 33 7 32 8 32 9 32 10 (least volatile) 32 Diﬀerent CDS Ascending -0.04% (0.55) -0. One way to reduce the number of transactions is to rise the amplitude of the band so that we buy only if the CDS drops by a noticeable amount.41) -0. we can see that a transaction cost of 0.27% (0.02% (0.73% annually (with a p-value of 0.66% (0.62% (0.39) -1.52% (0. combining both criteria does not yield better results than simply taking low-rated ﬁrms (the return is slightly higher.23% (0. we show results.10% (0.48) -3.62) For those ﬁrms.00 and a Sharpe ratio of 9.60) 6.54) 7. in table 6.01% 10 . every time the CDS spread drops we buy the stock today and sell it tomorrow (or another day if the CDS spread continues to drop).47) -0. So. they will reduce substantially our earnings.04% (0.04).54) 7.77% (0.39) 0. the portfolio management strategy (with equal weights) yields 30.

28) -3.74% 5.31% 11.71% 10.09% -16.01) Table 6: Diﬀerent values of band and transaction costs Cost/Band 0% 0.00) 3.05% (<1e-05) -2.24% 4 bp 29.69% (<1e-05) 3.63% 20.64% 14.10) -6.32% -1.28 % (0.12% 7.59% -5.34% -26.56% -4.45% (<1e-05) -23.38% -0.01% 0.27% 2 bp 8.22% (<1e-05) 13.72% -3.25% (0.97% -23.67% 18.88% 10 bp 29.14% 0 bp 1.06% -11.19% -9.09) -12.46% (<1e-05) 0.31% 0.06% -7.61% 23.04% -20.99% (<1e-05) 10.84% 11 .22% 13.33% -33.67% 8.25% -16.52% (<1e-05) 4.61% 12.71) -6.03% (<1e-05) -8.60% (0.44% (0.03% -15.15% -11.62% -4.16% (<1e-05) 19.51% (0.05% 0.36% 17.69% 20 bp 12.45% (1.84% 8 bp 22.44% -21.23% -9.18% (<1e-05) -3.31% 6 bp 25.07% 5.79% 27.34% 2.90% (0.93% 27.54% (0.07% 0.10% 0.02% 6.18) Proportional to CDS Variation 5.Table 5: Comparison of Volatilities CDS volatility group 1 (most volatile) 2 3 4 5 6 7 8 9 10 (least volatile) Portfolio Management Strategies for Diﬀerent CDS Equally Weighted -0.39% -28.73% -4.48% (<1e-05) 9.82% -1.43% 0.02) -10.48% (<1e-05) 3.89% 1.12% 0.

It was also shown in [4] that there was statistical correlation between IV variation and stock price variation one day later. Ideally.removes roughly 2% from our annualized returns. CDS spreads do predict stock prices variation both statistically (see [4]) and economically (section 5) for ﬁrms that have low credit ratings. Furthermore. taking a small but non zero band seems to be the best strategy. 6 Further Research In order to really study the economical signiﬁcance of the information content of CDS spreads to predict stock returns. Journal of Financial Economics. For a band of 4 bp. on the other hand. 12 . does not seem to change predictability. a transaction cost of 0. 2007. it does not remove completely the advantage of using this strategy (remember that the ﬁrms considered here had their stock prices drop 21. the returns are usually a huge improvement over keeping the stock during the whole period so that loosing 2% does not mean the strategy is not economically signiﬁcant. Acharya and Timothy C. For example. CDS volatility. (84):110–141.44% a year. it would be interesting to try to ﬁnd a realistic strategy using that information. However. Finally. on average). Insider trading in credit derivatives. option-implied volatility (IV). our investments can have Sharpe ratios as high as 9. On the other hand. is there a way to combine the use of CDS variation with another known strategy? We should also make the same analysis on other derivatives to see if stock returns can be predicted by them.15 which means the high returns cannot be explained solely by the risk taken. References [1] Viral V. 7 Conclusion As we have seen throughout this article. Johnson. For example.01% takes almost 2% per year on our returns. such a strategy should not be as transaction intensive as the strategies presented in this article. This is very costly.

Andrew W. Explaining credit default swap spreads with the equity volatility and jump risks of individual ﬁrms. 2009. 2009. The Econometrics of Financial Markets. 13 . [7] Ser-Huang Poon. FDIC Center for Financial Research Working Paper. Craig MacKinlay. Princeton University Press. and K. [3] John Y. equity. Hao Zhou. and Haibin Zhu. The Review of Financial Studies. Working Paper. Geert Rouwenhorst. 1997. 2006. Campbell. and Jose Varas. Owain ap Gwilym. Wiley Hoboken. Do equity markets favor credit market news over options market news.[2] Antje Berndt and Anastasiya Ostrovnaya. Winter 2009:18–32. A Practical Guide to Forecasting Financial Market Volatility. 2008. [6] Lei Meng. Lo. (2007-08). [8] Benjamin Yibin Zhang. Fan Yu. William N. 9(3):797–827. 2007. and bond markets. Goetzmann. The information content of option-implied volatility for credit default swap valuation. [5] Evan Gatev. AFA 2008 New Orleans Meetings Paper. 2005. The Journal of Fixed Income. and Zhaodong Zhong. and A. [4] Charles Cao. Pairs trading : Performance of a relative-value arbitrage rule. Volatility transmission among the cds.

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