The empirical relationship between the spreads of Credit Default Swaps and Bonds

Warren Buffet, the world’s richest man, once said that derivatives are financial “weapons
of mass destruction.” a term popularized by George W. Bush to describe nuclear arms.
Indeed financial derivatives have a far greater impact on the market than their underlying
due to their leverage effect. And the most popular and important credit derivatives
nowadays are credit default swaps with a current notional value of over 60 trillion US
dollars according to ISDA 1 (International Swaps and Derivatives Association) and 58
trillion US dollars according to BIS 2 (Bank for international settlement) respectively. That
is more than the whole world’s gross domestic product in the same year! 3

This paper examines the empirical relationship of CDS premium and credit spread by
testing on their theoretical equivalence derived by Duffie (1999). It begins with an
overview of CDS followed by the theoretical framework. The analysis starts with
explanation of testing methods and description of data. After confirming the existence of
the basis spread, this paper goes on to analyse the interactions of CDS spread and Bond
spread using econometrics methods like Cointegration and Granger Causality tests. Also
examined is the leadership of price discovery process between CDS market and traditional
bond market.