Can CDS indexes signal future turmoils in the stock market? A Markov switching perspective

Abstract

Single-name Credit Default Swaps (CDS) are considered the main providers of direct information related with a reference entity’s creditworthiness and, for this reason, they have often been the core of news on the current financial crisis. The academic research has focused mainly on the capacity of CDS in anticipating agencies’ official rating changes and—in this respect—on their superior signalling power, compared to bond and stock markets. The aim of this work is, instead, to investigate the ability of fluctuations in CDS indexes in anticipating the occurrence of stock market crises. Our goal is to show that CDS indexes may provide investors and institutions with early warning signals of financial distresses in the stock market. We make use of a Markov switching model with states characterized by increasing levels of volatility and compare the times in which the first switch in a high volatility state occurs, respectively, in CDS and stock market index quotes. The data set consists of daily closing quotes for 5 years CDS and stock market index prices, covering the time period from 2004 to 2010. In order to capture possible geographic differences in CDS index capacity of foreseeing stock market distresses, data referring to two different regions, Europe and United States, are analyzed.