Inter-Market Basis Relations

No-arbitrage relationships characterize relative prices of credit default swaps (“CDSs”) vis-à-vis bonds and equities issued by the same reference entities. We review the empirical academic literature on which of the three markets is the Primary Price Discovery Market (“PPDM”) and find that CDS spreads lead corresponding cash bond prices in price discovery. The PPDM is more empirically ambiguous when comparing CDSs and equities. We also review the empirical evidence on the impact of the introduction of CDSs on bond and equity markets’ liquidity, which broadly demonstrates that the introduction of single-name CDS trading initially has adverse impacts on the liquidity of related debt and equity markets, but that those effects are transitory and may be later reversed as the related markets reach a joint equilibrium.