The Profitability in the CDS Market

Abstract

The strategy by buying the CDS with the most negative past 1-day stock return and selling the CDS with the most positive past 1-day stock return generates 0.26 daily Sharpe ratio from 2002 to 2016. The profitability concentrates on the most liquid CDS with more quote counts, more market makers, and less bid-ask spreads. Our paper challenges this notion by proposing a hypothesis based on informed speculation and partially informed hedging in segmented stock and CDS markets to explain the profitability. One implication of the hypothesis is that CDS-based trading strategy captures information asymmetry of different hedging and speculative demands given distress risk. Consistent with the distress nature of the strategy, we find that the return dynamic represents the distress risk factor, which is priced in U.S. market. Particularly, using portfolio approach following Fama-French (1993), we find the positive distress risk and return trade-off. Additionally, we show that the momentum crashes (by Daniel and Moskowitz (2015)) is because loser stocks bear more distress risk thus earn higher distress risk premium than winner stocks.