Title: Revisiting the dynamics between CDS spreads and equity returns under a nonlinear approach
Authors: Dolores Robles - Universidad Complutense de Madrid (Spain) [presenting]
Jose-Luis Fernandez-Serrano - UNED (Spain)
Abstract: The relationship between equity and CDS markets between 2007 and 2018 is analyzed under a non-linear vector autoregression approach. We apply cointegration analysis to test the existence of stable long-term relationships between both markets in which the disequilibrium adjustment process may present nonlinearities. We study daily short and long term relationships between the equity price and the corresponding CDS spread of single-name issuers listed in the US and European equity markets. We study the lead-lag relationships with a non-linear vector error correction model and show that, although both variables respond to disequilibria in the long term relationship, equity returns leads changes in the CS spread. This result indicates that the price discovery process mostly take place in the equity market. We find that the adjustment to disequilibrium in the long term relationship presents a significant nonlinear component. We also test for short and long term Granger causality between markets in our nonlinear setting. When we consider separately the analysis distinguishing the crisis period (2007 - 2010) and the subsequent period of economic recovery (2011 - 2018) we find that the equity market keep leading the CDS market in both periods, although the CDS has greater predictive ability in the recovery period. Overall, we find nonlinearities in the dynamic comovements and causality between equity and CDS markets that change in periods of market turmoil.