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An Empirical Analysis of the Dynamic Relation between Investment-grade Bonds and Credit Default Swaps

by Roberto Blanco of the Banko de Espaņa,
Simon Brennan of the Bank of England, and
Ian W. Marsh of the Bank of England & CEPR

October 2005

Abstract: We test the theoretical equivalence of credit default swap (CDS) prices and credit spreads derived by Duffie (1999), finding support for the parity relation as an equilibrium condition. We also find two forms of deviation from parity. First, for three firms, CDS prices are substantially higher than credit spreads for long periods of time, arising from combinations of imperfections in the contract specification of CDSs and measurement errors in computing the credit spread. Second, we find short-lived deviations from parity for all other companies due to a lead for CDS prices over credit spreads in the price discovery process.

Keywords: Credit default swaps, credit spreads, price discovery.

Published in: Journal of Finance, Vol. 60, No. 5, (October 2005), pp. 2255-2281.

Previously titled: An Empirical Analysis of the Dynamic Relationship Between Investment-grade Bonds and Credit Default Swaps

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