How Could the CDS Market Affect Equity Markets?
If you only consider the movement of capital into the CDS market, then the two have no relationship. That is, a spike in the demand for protection on company ABC’s bonds should not, in and of itself, have any effect on the price of ABC’s stock. However, a spike in the demand for protection on ABC’s bonds will lead to a spike in the price for such protection. Equity traders could view this spike in the price of protection as an indication of deterioration in ABC’s credit condition. This is the critical link. If equity traders ignore the spike as an aberration, they will not take action based on the spike.
In times of panic, particularly one rooted in a shortage of credit, it is rational for equity traders to view a spike in the price of protection of an entity’s debt as cause for concern. Therefore it would be rational to hedge or liquidate equity positions in that company. Thus, given an increase in the price of protection for ABC’s bonds in the context of today’s markets, we should expect ABC’s equity price to drop.
Read the full story here, … very intriguing.