Credit Markets and Adverse Aggregate Shocks: An Application to the Financial Crisis

Abstract

Credit derivatives are financial products whose payoffs are linked to adverse outcomes. We use this linkage to derive a new factor capturing the range of adverse aggregate shocks and study its ability to explain the cross-section of returns during the financial crisis. The existing literature has already demonstrated the sensitivity of credit securities to information about extreme adverse shocks. Our study complements the existing literature by demonstrating that measures related to the range of potential adverse outcomes and not just one specific adverse scenario can be helpful in explaining equity returns.