CDS indexes

One interesting finding in this paper is the significant positive autocorrelation present in all the studied iTraxx indexes. This is possibly an indication of an inefficient iTraxx CDS index market where index changes are predictable. The economical significance of profitsfrom trading strategies exploiting such regularities, however, is an interesting issue left for future research.

Moreover, significant correlations between iTraxx CDS index spreads and spread changes on the one hand and stock prices and stock returns on the other hand reveal a close link between the two markets. CDS spreads have a strong tendency to widen when stock prices fall and vice versa. Furthermore, in OLS regressions, both current and lagged stock returnsare found to explain much of the variability in CDS spreads. This suggests that firmspecific information is embedded into stock prices before it is embedded into CDS spreads. Hence, the stock market seems to lead the CDS market in transmitting firm-specific information and this is important information for arbitrageurs and others. Again, it is a possible indication of an inefficient European CDS market.

Stock index return volatility is also found to be significantly correlated with iTraxx CDS index spreads; the spreads are found to increase (decrease) with increasing (decreasing) stock volatilities. The link is particularly strong for 3-month historical volatilities. These results are in line with the theoretical literature on credit risk that emphasizes the importance of stock volatility for default probability predictions and it is further evidence of the importance of volatility forecasting in credit risk modelling.