Credit Default Swaps (CDS), which are a form of insurance against debt, have been fluctuating recently due to the current credit market turbulence. Economies with loads of debt such as Dubai and Greece, saw a surge in their CDS spreads, as more people are protecting themselves from the possibility of default.
I wanted to test the correlation of CDS spreads and the equities indexes, so I did a time series analysis by comparing the movement of the Dubai’s 5 year CDS spreads and the Dubai Financial Market Index (DFM). Surprisingly, the graph below shows that the DFM index follows the movement of the CDS spreads with a -0.92 correlation. This inverse correlation means that by closely monitoring the CDS spreads you can have a hint of what lies ahead in the equities market.
To be honest, I do not have a solid justification behind this trend; however, I’m sure that it’s no coincidence. One reason that occurred to me is that creditors usually have a better idea on the entity as compared to equity holders as they have more access.
Dubai CDS Spreads
DFM Index
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good analysis Saud
I guess CDS is an indication of confidence.
When the spread rises, confidence is low, which reflects on the equities market
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it’s no surprise that you see stock prices falling as CDSs increase
Take it on a company level. CDS reflects the credit quality of an entity. If there are concerns regarding a certain company such as its liquidity, financial stability… etc, you see the CDS of that firm shoots up. why? in layman language, the buyer of the insurance or CDS (the company) will need to pay higher premium to the seller of the insurance or CDS (the investor) becasue now it has a higher probability of default and the investor will have to pay the principal amount to the company should it go bust. And of course once negative news are out investors start to dump the stock.
So imagine when this happens on a sovereign level. Who wants to hold assets of a country that has a question mark on its credit quality!
And Faisal you’re. the spike in the ITRAXX (measure of CDS) we witnessed in this recent crisis was driven more by investors’ sentiment than company specific reasons.
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Keynesian Reply:
May 13th, 2010 at 6:07 pm
Well-put!
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