Stock Return Predictability of Cross-Market Deviations in Option Prices and Credit Default Swap Spreads

Georgios Angelopoulos, Daniel Giamouridis, Georgios Nikolakakis: Cross-market deviations in (deep out-of-the-money) equity put option prices and credit defaultswap spreads of the same firm are temporary and predict future movements in the put options and credit default swaps (Carr and Wu, 2011).

Author(s):

Georgios Angelopoulos,

Professor of Finance, Athens University of Economics and Business

Daniel Giamouridis

Research Associate, EDHEC Business School

Georgios Nikolakakis

Researcher, Athens University of Economics and Business

We document that these deviations are only temporary and the prices of the two insurance contracts revert to their usual level shortly after they occur, on average within about one week. The process of reversion involves changes in the CDS and the equity option, and, as we show for the first time, also involves largely predictable changes in the equity values of the reference firm. The predictability we document is an integral, yet unattended, component of the predictability of cross-market deviations documented in previous work. We observe that large deviations in the relative pricing of equity options and CDS are on average followed by equity (option and spot) prices that are consistent with the price history of the CDS contract (and are contrary to the price history of the option prices). This is generally consistent with informed trading in credit markets. However we argue that informed trading in the CDS markets only partly explains the predictability pattern we document. An alternative, not mutually exclusive explanation, which suggests that capital structure arbitrage activity dictates the future path of equity (option and spot) prices, cannot be ruled out.

Type: Working paper
Date: le 05/03/2012
Research Cluster : Finance

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