On the Relationship between Asian Sovereign Credit Default Swap Markets and Equity Markets

Abstract

The Merton-type structural model, when extended to sovereign issuers, suggests a negative relationship between sovereign credit default swap (CDS) spreads and stock prices. Capital structure arbitrage strategy that exploits such relationships should foster the integration of CDS and the stock market and improve price discovery. This paper studies the dynamic relationship between sovereign CDS spreads and stock prices for seven Asian countries for the period from January 2001 to February 2007. We find a strong negative correlation between the CDS spread and the stock index for most Asian countries. A long-run equilibrium price relationship is found for China, Korea, and Thailand. The limited integration in other countries may arise from market frictions and model applicability. In terms of price discovery, CDS markets play a leading role in five out of seven countries. The stock market has a feedback effect for two countries and dominates price discovery for only one country. Therefore, equity investors should span the CDS market for incremental information.

Keywords: Sovereign credit default swaps, capital structure arbitrage, price discovery, feedback effect

JEL Classification: G14, G15, C22