Three Essays on Systematic Information Flow Between Credit Derivative and Equity Markets
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I undertake a comprehensive analysis of the lead-lag relationship between the systematic investment grade and high yield credit derivative and equity markets and their sub-indices within a robust differenced VAR, asymmetrical Granger causality and VARMA framework. I operationalize a broad set of liquidly tradable CDX credit derivative indices produced by Markit and compare them to closely matched equity portfolios from which I construct indexes. Prior efforts studying informational flow between these two markets have focused almost exclusively on the unsystematic (firm-specific) relationship. I observe a distinct heterogeneity in the pattern of informational flow across the different market segments studied. In the systematic investment grade markets, I document a persistent semi-strong form of capital market efficiency in which information, irrespective of whether it is positive or negative, is impounded in a quick and timely manner in both markets. In the high yield market, I observe a two-way causality, meaning that certain types of information are impounded more efficiently in each market. The lead-lag relationship from the credit to the equity market is regime dependent, with causality more prevalent under adverse market conditions and the effects hold most strongly for the aggregated high yield and BB-rated indices. Finally, I document a persistent causality flowing from the equity to the credit sectors with no causality in the opposite direction in the investment grade rated sub-indices, meaning that sector based credit investors are reactive to developments in the equity market. These distinctly different results across market segments suggest very different behavior on the part of investors in how they use credit derivatives indexes and have practical for implications for arbitrageurs seeking to exploit cross market informational efficiencies.