Price Discovery Dynamics of Corporate Credit Default Swaps and Bonds

This paper empirically analyzes in a time-varying context if the U.S. corporate Credit Default Swaps (CDS) and bond markets of 81 reference entities reflect the same information on their prices between October 2004 and December 2010. The analysis shows that the theoretical no-arbitrage relation between CDS and bond spreads holds during economic stable times, but is violated as soon as markets are exposed to economic turmoil as in the financial crisis starting in August 2007. The difference between CDS and bond spreads, called the basis, is more volatile the lower the firms are rated. The price discovery is unaffected by the reference entities' credit rating and is strongly time-varying. Nevertheless the CDS spreads lead the price discovery process. Price discovery is significantly influenced uniquely by counterparty risk only when economic risks achieve abnormal levels as during the 2007/2008 financial crisis. Other risks as interbank liquidity risk, global risk and financing costs aren't considered by CDS traders when markets are facing abnormal risks. The more the markets are exposed to counterparty risk, defined as the risk that the CDS seller defaults, the less the price discovery takes place in the CDS market and therefore the more the bond spreads tend to reflect credit risk more efficiently than the CDS spreads. Thus market participants have the tendency to abscond from the CDS market as soon as counterparty risk is elevated. Because price discovery still takes place in the CDS market, economic risks are strongly underestimated by market participants.