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Price convergence between credit default swap and put option: New evidence

Author

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  • Chan, Ka Kei
  • Kolokolova, Olga
  • Lin, Ming-Tsung
  • Poon, Ser-Huang

Abstract

Credit default swaps and deep out-of-the-money put options can be used for credit protection, but these markets are not perfectly integrated, leading to different implied hazard rates. The differences in the implied hazard rates are linked to deviations between consensus rating-based hazard rate curves in the two markets, and a residual component related to market frictions. We show that both components diminish over time, but their convergence is asynchronous. A trading strategy based on a joint signal from the curve and residual differences outperforms a conventional trading approach that relies on the absolute differences between the implied hazard rates. Hedge funds are likely to exploit within-market inefficiencies and deviations from rating-based curve, but they do not seem to profit from market segmentation.

Suggested Citation

  • Chan, Ka Kei & Kolokolova, Olga & Lin, Ming-Tsung & Poon, Ser-Huang, 2023. "Price convergence between credit default swap and put option: New evidence," Journal of Empirical Finance, Elsevier, vol. 72(C), pages 188-213.
    • Handle: RePEc:eee:empfin:v:72:y:2023:i:c:p:188-213
    DOI: 10.1016/j.jempfin.2023.03.008
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    More about this item

    Keywords

    Credit default swap (CDS); Deep out-of-the-money put option; Market segmentation; Convergence; Trading strategy;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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