Micro-efficiency vs. Macro-(in)efficiency: The Role of Default Risk in Stock Return Predictability

Event Date: 2 February 2022

Speaker: Alexandre Rubesam, IESEG School of Management, Paris

Time: 2pm (Zoom details emailed to faculty the week prior, otherwise please email donna.irving@strath.ac.uk)

Abstract:

Starting from a structural model of the firm, we develop a model of strategic trading to examine the transmission of pricing information from the credit market to the stock market. In this model, informed traders engage in Capital Structure Arbitrage (CSA) strategies to exploit mispricings between a company's equity, corporate bonds, and single-name credit derivatives. We use a large dataset of S&P 500 firms and an extended timeframe (2008–2020) to examine the model's empirical implications. We extend econometric tests developed in the market efficiency literature to firms subject to corporate default risk. We find that (i) highly-leveraged firms exhibit a relatively low level of excess stock volatility, (ii) stock market efficiency increases along with firm leverage, and (iii) default risk information persists in leveraged firms' equity returns contrary to global or sector stock indices. In addition, an active Credit Default Swap (CDS)  market for single names improves the equity market efficiency significantly and helps align stock prices with their fundamental values.

Published: 9 February 2022