Managers are always looking for a better way of predicting stock market returns. Sometimes they have to look in some seemingly obscure places.
Fan Yu, an associate professor of finance at Michigan State University, East Lansing, has found a relationship between credit default swap spreads and implied volatilities on individual stock options that can forecast stock returns.
This relationship is particularly strong for firms with lower credit ratings, higher CDS (credit default swaps) spread volatiles, and more actively traded options, according to a draft paper he co-authored with Charles Cao, professor of finance, and Zhaodong Zhong, a Ph.D. candidate in finance, both at the Smeal College of Business at the Pennsylvania State University, University Park.
While changes in implied volatility consistently forecast future CDS spread changes, the reverse does not hold. We interpret these findings as broadly consistent with informed traders preferentially using the options market, and to some extent the CDS market, to exploit their information advantage, the paper said.
Fan Yu has contributed thoughtful ideas in the areas of credit risk, fixed income and derivatives after completing Ph.D.s in both physics and economics, said Tanya Styblo Beder, chairman of SBCC Group, New York-based consulting firm whose areas of focus include risk management and hedge funds.
In other research, Mr. Yu examined the risk and return of capital structure arbitrage, linking the mispricing of a company's debt and equity. This research, too, connects a company's equity price with its credit default spread.
In his paper, Mr. Yu writes, that when the market spread is substantially larger than a predicted spread, an arbitrageur could consider two views: the price reflected in equity market is a better assessment of the price of credit protection and sell credit protection, or the market spread is right and the equity market is slow to react to relevant information, and thus sell equity. In practice, the arbitrageur is probably unsure, so that he does both and profits if the market spread and the model spread converge to each other, his paper said.
Mr. Yu's model helps calculate credit spreads and risk in credit default market and helps determine when to buy and sell equity to hedge credit default swaps.
Mr. Yu said he doesn't consult to money managers. He said he is focused on developing his academic career. My priority is publishing not consulting, he said.Barry B. Burr