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Term Structure of Credit Default Swap Spreads and Cross-Section of Stock Returns

Last Updated on 10 February, 2024 by Rejaul Karim

Diving into the intricate interplay between credit default swap (CDS) spreads and stock returns, “Term Structure of Credit Default Swap Spreads and Cross-Section of Stock Returns” by Bing Han and Yi Zhou unveils a compelling relationship with far-reaching implications.

Presented as McCombs Research Paper Series No. FIN-01-11 and an AFA 2012 Chicago Meetings Paper, this research, originating from the University of Toronto, Rotman School of Management, and San Francisco State University, was first penned on March 1, 2011, with revisions up to June 18, 2011. The study illuminates a distinctive insight: the slope of a firm’s CDS spread term structure serves as a potent predictor of future stock returns.

Intriguingly, stocks with a low CDS slope consistently outperform those with a high CDS slope, showcasing a monthly overperformance exceeding 1% for the subsequent six months. Notably, this phenomenon eludes conventional explanations, remaining untethered from standard risk factors, stock characteristics, default risk measures, or changes in CDS spreads.

Unraveling the dynamics, the research elucidates that while CDS slope effectively forecasts future changes in CDS spreads, its information content is gradually assimilated into stock prices, exerting a pronounced impact primarily on stocks grappling with high arbitrage costs.

Abstract Of Paper

The slope of a firm’s term structure of credit default swap (CDS) spreads (five-year spread minus one-year spread) negatively predicts future stock returns. Stocks with low CDS slope on average outperform stocks with high CDS slope by over 1% each month for the next six months. Our result can not be explained by standard risk factors, stock characteristics, default risk measures or changes in CDS spreads. We find that CDS slope positively predicts future changes in CDS spreads, but the information content of CDS slope only slowly gets incorporated into stock price. CDS slope predicts return mainly for stocks facing high arbitrage costs.

Original paper – Download PDF

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Author

Bing Han
University of Toronto, Rotman School of Management

Yi Zhou
San Francisco State University

Conclusion

In examining the relationship between overnight and intraday returns, the study expands its scope to encompass recent, relatively tranquil market years. Notably, the autocorrelation between overnight and intraday returns endures among smaller stocks, although not for the S&P500.

This relationship exhibits a monotonic nature, signifying that stronger overnight returns tend to correlate with more pronounced opposite intraday returns. Additionally, evidence suggests a reduction in market volatility in recent years, with the market factor playing a more significant role in stock returns.

This retrospective analysis provides valuable insights into the intricate dynamics between overnight and intraday returns, offering a nuanced perspective on market behavior and volatility trends.

Related Reading:

Momentum and Aggregate Default Risk

Market States and Momentum

FAQ

Q1: What is the key finding of the research on the term structure of credit default swap (CDS) spreads and stock returns?

The research reveals a significant relationship between the slope of a firm’s CDS spread term structure (five-year spread minus one-year spread) and future stock returns. Stocks with a low CDS slope consistently outperform those with a high CDS slope, showcasing a monthly overperformance exceeding 1% for the subsequent six months.

Q2: How does the information content of CDS slope impact stock returns, and what distinguishes this relationship from conventional explanations?

While CDS slope effectively predicts future changes in CDS spreads, its information content is gradually assimilated into stock prices. This impact on stock returns remains distinct from conventional explanations, as it is untethered from standard risk factors, stock characteristics, default risk measures, or changes in CDS spreads.

Q3: What is the significance of CDS slope in predicting stock returns, and for which type of stocks does it have a pronounced impact?

The CDS slope serves as a potent predictor of future stock returns, particularly for stocks facing high arbitrage costs. Stocks with low CDS slope consistently outperform, with a monthly overperformance exceeding 1% for the next six months. This finding highlights the distinctive role of CDS slope in forecasting stock returns and its relevance in the context of high arbitrage costs.

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