Analysis of relationships between equity, bond and credit markets

Abstract

The research topic aims to establish the correlation between the Equity, Bond and Credit Markets. With Credit markets acquiring significance over the period of last 2 years, it becomes increasingly important to analyze the various correlations in order to utilize any market imperfections. The project also aims to establish the causality and the directionality of this relationship. In order to establish these links, we use the European Investment Grade stock indices as our benchmark. The Eurostoxx 50 index has been used for Equities, VDAX Volatility index (symbol: V1X) has been used for 3 month implied volatilities, Eurobund Futures (Expiry – 1m) Index has been used for Government Bonds (Maturity – 7Y) and Itraxx 10Y CDS Index for analyzing the CDS spreads. Knowledge about the link between stock returns, stock return volatilities and CDS spreads is not only important for risk managers using Credit Default Swaps for hedging purposes, but also to anyone trying to profit from arbitrage possibilities in CDS market. From the analysis, we ascertain that CDS spreads tend to narrow with rising equity prices and vice versa. Stock price volatility index also appears to have a significant correlation with CDS prices. CDS Spreads also appear to increase with bond prices. This research involves analysis using statistical tools like regression, Granger causality tests and cointegration analysis to identify any relationships and/or causality that may exist between these markets.