The fast and the furious—Stock returns and CDS of financial institutions under stress

Abstract

This paper examines the link between equity and credit markets for major financial institutions during times of heightened stress and increased default risk. We focus on sizeable US firms, which either failed or required substantial government support during 2008. Our examination of daily lead–lag relationships of 5-year credit default swaps, equity prices, and implied option volatility shows that equity and credit markets become more integrated during times of heightened stress and that fast equity price changes lead furious CDS spread changes. We confirm a strong positive link between changes in CDS spreads and in option implied volatility and find that adjustments take place simultaneously. Our results point at a regime dependent relationship between equity and credit markets and have practical relevance for capital markets regulation, e.g. the ban on short selling of financial stocks.