An Analysis of Price Discovery from Panel Data Models of CDS and Equity Returns

We propose a panel data model of price discovery. We find that the stock market contributes to price discovery in most sectors while the Credit Default Swap (CDS) market contributes to price discovery in only a few sectors. We discover that in sectors where both the stock market and the CDS market contribute to price discovery, it is the stock market that dominates the price discovery process. When we consider investment grade stocks, the importance of the CDS market in price discovery improves but the stock market still dominates the price discovery process. The results for different sizes of stocks generally suggest that both markets are important for price discovery but it is the stock market that dominates. We also find that while the price discovery process was affected by the 2007 global financial crisis, the stock market still dominated the price discovery process. Finally, in an economic significance analysis, we show that investors in the CDS market are able to make relatively more profits from a forecasting model that takes into account price discovery compared to a model that simply ignores the role of price discovery.