Credit Default Swap Spreads and Implied Cost of Equity

I examine the relationship between credit default swap spreads and implied cost of equity. These two empirically observable measures are surrogates for the larger concepts cost of debt and cost of equity. Using a sample of quarterly observations from 2004-2012 for 93 firms contained in the Markit CDX index, I find that the relationship between CDS spreads and implied cost of equity is overall positive. The relationship is, however, less positive in situations in which incentives for asset substitution are more likely to exist, or if CDS spreads are at a high level. These findings are consistent with theoretical predictions.