An empirical comparison of credit spreads between the bond market and the credit default swap market - August 2004

This paper compares the pricing of credit risk in the bond market and the fast-growing credit default swap (CDS) market. The empirical findings confirm the theoretical prediction that bond spreads and CDS spreads move together in the long run. Nevertheless, in the short run this relationship does not always hold. The deviation is largely due to different responses of the two markets to changes in credit conditions. By looking into the dynamic linkages between the two spreads, I find that the CDS market often moves ahead of the bond market in price adjustment, particularly for US entities. Liquidity also matters for their role in price discovery. Surprisingly, the terms of CDS contracts and the short-sale restriction in the cash market only have a very small impact. BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The views expressed in them are those of their authors and not necessarily the views of the BIS. Copies of publications are available from: Bank for International Settlements Press & Communications CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2004. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISSN 1020-0959 (print) ISSN 1682-7678 (online)