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Price Discovery of Credit Spreads in Tranquil and Crisis Periods

Avino, Davide and Lazar, Emese and Varotto, Simone (2012): Price Discovery of Credit Spreads in Tranquil and Crisis Periods.

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Abstract

Credit spreads can be derived from the prices of securities traded in different markets. In this paper we investigate the price discovery process in single-name credit spreads obtained from bonds, credit default swaps, equities and equity options. Using a vector error correction model (VECM) of changes in credit spreads for a sample that includes the 2007-2009 financial crisis, we find that during periods of high volatility, price discovery takes place primarily in the option market, whilst the equity market leads the other markets during tranquil periods. By adding GARCH effects to the VECM specification, we also find strong evidence of volatility spillovers from the option market to the other markets in crisis periods. Finally, we show how time-varying measures of price discovery can be generated using GARCH models.

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