The 2008 Financial Crisis and the Dynamics of Price Discovery among Stock Prices, CDS Spreads, and Bond Spreads for U.S. Financial Firms

Proliferation of traded derivatives that relate to the same underlying—such as stocks, bonds, and credit default swaps (CDS) all tied to the value of an underlying firm—raises questions about which instrument leads the adjustment to a new equilibrium when information enters the market. In this article, the authors explore the issue of using CDS, bonds, and stocks of 10 financial firms before and during the crisis of 2008. Using a cointegration framework, they calculate each security’s contribution to overall price discovery. They find the stock market to be the most informative, followed by the CDS market, with the bond market least of all. Before the crisis period, about two-thirds of price discovery occurred in the equity market and about one-quarter in the CDS market. From fall 2007 through 2008, however, the influence from stocks dropped to about 50%, while the CDS market’s contribution increased to close to 40%. TOPICS:Derivatives, security analysis and valuation, financial crises and financial market history