News‐Specific Price Discovery in Credit Default Swap Markets

• Author: Ian W. Marsh,Wolf Wagner
• Published date: 01 May 2016
• Date: 01 May 2016
• DOI: http://doi.org/10.1111/fima.12095

News-Specific Price Discovery in Credit

Default Swap Markets

Ian W. Marsh and Wolf Wagner∗

We examine the lead and lag relation between equity and credit default swap (CDS) markets. We

find that price discovery in equity markets only leads CDS markets following aggregate positive

news and not so following other news. While difficult to reconcile with standard asset pricing

theories, asymmetric price adjustment is common in goods markets, arising from intermediary

power. We provide an explanation for this asymmetry based on dealers exploiting informational

advantages vis-`

a-vis investors with hedging motives. Consistent with this explanation, we find

that the patterns we document are related to firm-level proxies for hedging demand, as well as

economy-wide measures of information asymmetries.

Of key interest to the finance profession is understanding how new information is incorporated

into securities prices. One approach is the study of price discovery across markets. If new

information is simultaneously priced into different markets, this is evidence of informational

efficiency. Evidence of one market pricing information faster than another suggests market

inefficiencies. Studies on price discovery often find that one market leads in price discovery.1

In this paper, we explore the idea that inefficiencies in price discovery may be news-specific

as traders in one market may have an advantage with respect to one type of information and not

all information equally. In this case, price discovery would not unconditionally favor one market

over another,but would depend upon the type of innovation. It would also suggest a more nuanced

view regarding the informational efficiency of markets in that it may only hold conditional on

specific information.

We focus our analysis on price discovery in equity and credit default swap (CDS) markets.

The evidence concerning whether equity returns lead CDS price changes is mixed. Longstaff,

Mithal, and Neis (2005) suggest that both markets move simultaneously (but that both lead

the corporate bond market), while Norden and Weber (2009) and Hilscher, Pollet, and Wilson

(2012) find that equity returns lead CDS price changes much more frequently than the other way

around.2Acharya and Johnson (2007) demonstrate that under certain market conditions (typically

The authors gratefully acknowledgef inancial support fromNCCR Trade Regulation. Wewould like to thank Ana-Maria

Fuertes, Aneel Keswani, Chensheng Lu, Richard Payne, Asani Sarkar, seminar participants at Aberdeen University and

Cass Business School for constructive discussions, and an anonymous hedge fund for providingsome of the data used in

the project. The paper has benefitted from the comments of an anonymous referee and Marc Lipson (Editor). Excellent

research assistance fromNorman Niemer is gratefully acknowledged.

∗Ian W. Marsh is a Professorin the Department of Finance at the Cass Business School in London, UK. Wolf Wagner is a

Professor of Financeat the Rotterdam School of Management at Erasmus University in The Netherlands.

1For example, Chan (1992) finds that equity index futures tend to lead the cash index. Hou (2007) and Chordia, Sarkar,

and Subrahmanyam (2011), along with many others, examinelead-lag effects between large and small cap equities, while

Hotchkiss and Ronen (2002) consider lead-lags between corporate bonds and equities.

2There is solid evidence that with very few exceptions, CDS markets price information faster than corporate bond

markets, although arbitrage relationships tie credit spreads and CDS prices together in the long run (Blanco, Brennan,

and Marsh, 2005). There is also evidence that the corporate bond market lags the stock market (Kwan, 1996; Downing,

Underwood,and Xing, 2009).

Financial Management •Summer 2016 •pages 315 – 340

316 Financial Management rSummer 2016

bad news about the credit quality of specific firms), changes in CDS prices lead equity retur ns, a

phenomenon they ascribe to insider trading by banks with access to nonpublic information about

their customers.

We first analyze unconditional price discovery. We use daily panel data on US firms, larger

in both cross-section and time series dimensions than typically examined previously, to study

the lead-lag relationships between equity returns and CDS price changes. We find that equity

returns robustly lead CDS price changes. There is very little support for the thesis that CDS price

changes lead equity returns. This is strong evidence in favor of an unconditional informational

advantage of equity markets, particularly since we have constructed our sample to include only

the most liquid CDS entities thus effectively biasing the sample against finding an equity lead.

The key focus of our paper is to investigate more precisely the nature of the information that

is priced faster in equity rather than CDS markets. Do equity prices lead CDS prices for all

types of information or only in response to some information? We first ask whether common

and firm-specif ic information are priced at different speeds. The evidence, based on alternative

factor decompositions, is clear. The CDS market is slow to price common information, while it

prices firm-specif ic news at about the same speed as equity markets. The dominant component

of systematic information in equity returns that is priced slowly by the CDS market is, rather

surprisingly, the (equity) market factor. One might have expected the (single) market factor to be

more efficiently priced than news specific to individual firms.

In addition, we examine whetherthe lead-lag depends upon whether there is positive or negative

news in the equity market. We find that positive and negative equity market returns appear to

be priced at different speeds by the CDS market. Most of the lagged response of CDS prices is

driven by slowCDS price changes in response to positive equity market returns. Our f indings are

complementary to Acharya and Johnson (2007). Acharya and Johnson (2007) argue that CDS

markets can lead equities when there is bad news about a specific company, while our results

suggest that CDS markets lag equities in pricing good news about the general economy.

What can account for the news-specific nature of price discovery? We bring forward an

explanation based on the importance of different investor groups in the twomarkets. While a wide

range of investors with very diverse trading interests are active in equity markets, participation

in the CDS market is much more limited. Kapadia and Pu (2012) note that the CDS market

is actively traded by sophisticated arbitrageurs, but a key reason for the development of CDS

markets is institutional investors’ demand (predominantly by banks) for an instrument capable

of hedging credit risks. The significant presence of hedgers in CDS markets (together with the

presence of barriers to arbitrage) can explain both the aggregate-idiosyncratic news and positive-

negative news asymmetries. As these investors are likely to be well informed about news specific

to the firms in their portfolio, CDS markets respond eff iciently to such news. However, hedgers

of firm risks are likely to focus less on macro-news. In response to positive equity market news,

dealers in the CDS market can keep prices high and exploit their informational advantage. This

dampens price adjustments in the CDS market and causes an equity-lead specific to positive

macro news. Conversely, in the event of bad equity marketnews, CDS prices rise immediately as

rapid adjustment is in the interest of dealers.3

3Asymmetric responses to positive and negativeprice shocks are widespread in goods markets (Bacon, 1991) where the

phenomenon is driven by consumers facing search costs that afford intermediaries a degree of market power. Recently,

Green, Li, and Sch¨

urhoff (2010), interpreting search costs as informational asymmetries, find that such asymmetries can

also occur in financial markets (municipal bond markets).