Does CDS Slope Predict Future Stock Returns? Evidence from the Korean Market

Abstract

We provide evidence that current CDS slope negatively predicts future stock returns over several months in the Korean market. The entire sample period covers January 2003 through June 2009. The empirical results are as follows. First, when constructing quartile portfolios based on the slope of CDS spreads, we find that predictive power of CDS slope lasts for seven months. In addition, the lower the CDS slope is, the higher average stock return is. Specifically, a slope-based strategy of buying the lowest slope and selling the highest slope makes profits over 2% each month. The profitability is statistically and economically significant even after controlling for some risk factors. We also find that the results are robust to various sub-samples, portfolio-weighting schemes, as well as the number of sorted portfolios. This abnormal return cannot be explained by standard risk factors, default risk, and expectation hypothesis.