Relationship Crisis?: - An Empirical Study of the Theoretical Equivalence Relationship between CDS and Bond Markets in a Time-Varying Context

Abstract: This paper compares prices of traded European corporate credit risk in the CDS and bond market in a time-varying context. Theory predicts that the two markets would price credit risk equally in the long-run. However, our empirical findings between the two time periods chosen for this study contradict this theory. The interrelationship between the two markets is found to be more pronounced during the financial crisis of 2007-2009 compared to the period before. Despite of this, the CDS spreads are on average significantly lower than the corresponding bond spreads during the financial crisis, in contradiction to previous research findings on other time periods. Furthermore, the short-run dynamics of each market’s relative contribution to price discovery is examined. In line with previous research on US data, our results imply that the CDS market’s contribution to price discovery dominates the full sample, but the relative contribution of the bond market increases during the financial crisis.