Healthy... Distress... Default
Zura Kakushadze

TL;DR
This paper presents an analytically solvable model of stock dynamics with regime switching, enabling extraction of expected returns from CDS spreads, which could inform equity trading strategies.
Contribution
It introduces a simple, exactly solvable model linking CDS spreads to stock returns, providing a new method to derive market sentiment signals.
Findings
Model effectively captures regime switching in stock dynamics.
Expected returns can be inferred from CDS spreads.
Potential application in cross-sectional arbitrage strategies.
Abstract
We discuss a simple, exactly solvable model of stochastic stock dynamics that incorporates regime switching between healthy and distressed regimes. Using this model, which is analytically tractable, we discuss a way of extracting expected returns for stocks from realized CDS spreads, essentially, the CDS market sentiment about future stock returns. This alpha/signal could be useful in a cross-sectional (statistical arbitrage) context for equities trading.
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Taxonomy
TopicsInsurance and Financial Risk Management · Credit Risk and Financial Regulations · Capital Investment and Risk Analysis
