Do Credit Default Swap Prices Reveal the Presence of Informed Trading?

Abstract

We attempt to answer a key question whether credit default swap (CDS) prices and price changes contain private information that are used by informed traders within 24 hours to cross-trade in the related equity market. By disaggregating daily stock return into day (exchange trading hours), evening, and night returns, we find that the credit default swap return of a stock, with high credit spread and high idiosyncratic volatility (hard-to-value), negatively impacts the next market-hours stock return in a significant way both via panel regression tests and via portfolio profitability tests. For stocks with low idiosyncratic volatility and thus higher predictability, the CDS return impact is milder and is opposite in direction, indicating a pattern of hedged investing. We show empirically that by evening after market-hours, the impacted stock return would reverse partially explanable by the well-established observation of trading overconfidence due to private information bias. For the case of low credit ratings stocks with high opaqueness or being hard-to-value, there is the additional interesting finding that large stock price changes due to CDS impact do not evidence any partial reversal on the eve of days in which actual credit rating downgrade happened. This reinforces the evidence of the presence of informed trading. We also find that limit-to-arbitrage such as stock illiquidity and short-sale constraint cannot fully explain the predictive results on stock returns based on CDS return signals.