Pairing market risk with credit risk

This paper uses an exclusive proprietary data set of European Credit Derivatives and VIX markets, covering a sample of 5 to 7 years, to study the nature of the theoretical link between credit risk and market risk, originally postulated in the work of Merton. This allows us to establish cointegration in the VIX and iTraxx/CDS markets in a demand and supply framework where arbitrageurs exploit temporary equilibrium mispricing following pairs strategies. By shorting the outperformer and buying the underperformer asset, arbitrageurs achieve equilibrium price convergence. Profits from pairs strategies, represented via VECM parameters, guarantee positive expected profits. Empirical estimates suggest that temporary mispricing exists due to a lead of VIX in the discovery process. We contribute to the existent literature suggesting that VIX as an improved predictor of CDS spreads.