Healthy... Distress... Default

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.