The correlation between the debt and equity markets
The correlation between the debt and equity markets’ measures of risk has been extremely strong over the recent years. External shocks, for example the tragic events of September 11, 2001, the LTCM disaster in 1998 or the Asian crisis, have a substantial impact on credit spreads as well as on implied equity volatility. Consider the relationship between implied volatility of call options on Dow Jones Euro Stoxx 50, and the spread versus government bonds of the MSCI Euro corporate bond index.
One way of interpreting implied volatility on an equity index is as the compensation that the investors receive for taking on equity risk. The index of credit spreads represents the additional yield investors demand for holding corporate debt over benchmark government debt. While there have at times been brief periods of divergence, these two risk measures typically move together. For example, in 1993/94 banks in the United States cleaned up their balance sheets by writing down nonperforming assets, causing the VIX index, representing the implied volatility of put and call options on the S&P 100, to fall to a historical low just above 10 percent. The decline in implied equity volatility triggered a credit spread rally. Asimilar thing happened in 2002. Average credit spreads collapsed by half, as did optionimplied volatility. So the decline in volatility was a major driver of credit spread tightening. However, one tends to find that when implied volatility falls below a certain threshold the effect of small changes on spreads is rather subdued.
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