An Efficient Market Study of European CDS and Equity Markets

Sammanfattning: This thesis investigates the price discovery process between the stock and the credit default swap market (CDS). We link the financial theory of efficient markets and the underlying models and conditions involved in CDSs, the stock market and financial crashes. This study uses publicly listed firms and the European market CDS series to construct a matched stock portfolio and uses financial data collected between the years 2019 to 2021. The purpose is to better understand the price discovery process during a potential new type of crisis in modern financial history. It could potentially allow portfolio managers, traders, arbitrageurs and stakeholders who monitor systematic indices to gauge the level of risk in the overall economy. It can also better inform regulators about how the CDS and the stock market reacted to each other during the COVID-19 pandemic. This deductive and quantitative research is based on secondary data gathered from the Eikon financial database. It uses a vector autoregressive model to test a hypothesis regarding the price discovery process between the stock and CDS portfolios.  Our results show that when using only the variables for the CDS and stock market, both variables cause each other, which is to say a feedback effect is present between the CDS Europe index and the matched portfolio of stocks. When adding the three control variables, the stock variable no longer causes the CDS variable, while the CDS variable still causes the stock variable. We conclude that the European credit default swap index leads the matched portfolio of stocks in the price discovery process with our chosen variables.