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Stock Prices and Stock Return Volatilities Implied by the Credit Market

Byström, Hans LU (2016) In Journal of Fixed Income 25(4). p.32-54
Abstract
In this article, the author compares equity and credit investors' opinions on price formation in the equity market. More exactly, he inverts the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for companies in the DJIA index. The credit-implied stock prices often deviate significantly from actual stock prices over the long term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA. In an attempt to demonstrate potential applications of credit-implied stock prices, the author constructs simple "capital structure arbitrage" trading strategies based on past credit-implied prices. These... (More)
In this article, the author compares equity and credit investors' opinions on price formation in the equity market. More exactly, he inverts the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for companies in the DJIA index. The credit-implied stock prices often deviate significantly from actual stock prices over the long term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA. In an attempt to demonstrate potential applications of credit-implied stock prices, the author constructs simple "capital structure arbitrage" trading strategies based on past credit-implied prices. These strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. The author demonstrates how an alternative credit-based "fear gauge," comparable to the CBOE VIX but emanating from the credit market, can be constructed using the credit-implied volatilities. He calls this implied volatility index the Credit-Implied Volatility Index (CIVX). Finally, a plot of the entire term structure of implied volatilities demonstrates a distinct maturity volatility skew. (Less)
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author
organization
publishing date
type
Contribution to journal
publication status
published
subject
in
Journal of Fixed Income
volume
25
issue
4
pages
23 pages
publisher
institutional investor journal
external identifiers
  • Scopus:84976873290
ISSN
1059-8596
DOI
10.3905/jfi.2016.25.4.032
language
English
LU publication?
yes
id
0fcffec1-2550-44ac-9759-523333b735b4
date added to LUP
2016-05-06 10:18:53
date last changed
2017-01-01 08:25:20
@article{0fcffec1-2550-44ac-9759-523333b735b4,
  abstract     = {In this article, the author compares equity and credit investors' opinions on price formation in the equity market. More exactly, he inverts the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for companies in the DJIA index. The credit-implied stock prices often deviate significantly from actual stock prices over the long term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA. In an attempt to demonstrate potential applications of credit-implied stock prices, the author constructs simple "capital structure arbitrage" trading strategies based on past credit-implied prices. These strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. The author demonstrates how an alternative credit-based "fear gauge," comparable to the CBOE VIX but emanating from the credit market, can be constructed using the credit-implied volatilities. He calls this implied volatility index the Credit-Implied Volatility Index (CIVX). Finally, a plot of the entire term structure of implied volatilities demonstrates a distinct maturity volatility skew.},
  author       = {Byström, Hans},
  issn         = {1059-8596},
  language     = {eng},
  month        = {05},
  number       = {4},
  pages        = {32--54},
  publisher    = {institutional investor journal},
  series       = {Journal of Fixed Income},
  title        = {Stock Prices and Stock Return Volatilities Implied by the Credit Market},
  url          = {http://dx.doi.org/10.3905/jfi.2016.25.4.032},
  volume       = {25},
  year         = {2016},
}