The role of the leverage effect in the price discovery process of credit markets

Starting from the analysis of a levered firm’s capital structure, I show that corporate default risk becomes measurable through the leverage effect, i.e., the negative correlation observed between stock returns and changes in stock volatility. In this model, the firm’s debt-to-asset ratio governs the elasticity of default probabilities relative to equity prices. I use a large dataset of S&P 500 firms and an extended timeframe (2008–2019) to examine the model’s empirical implications. First, the firm’s corporate leverage enhances the transmission of pricing information from the stock to the credit default swap (CDS) market. Second, equity and credit markets are more likely to be co-integrated when firms employ a higher debt-to-asset ratio. Although the stock market generally dominates the price discovery process, a small cluster of highly-leveraged firms exhibits a dominant CDS market share. Under the effect of corporate leverage, the credit market attracts informed trading and arbitrage resources.