Watching markets work: ICICI stock and CDS

Pravin Palande has an article in Economic Times about the recent difficulties at ICICI Bank.

We know that credit risk can be inferred using stock prices (through the Merton / KMV style models) and the credit default swaps (CDS) are of course all credit risk. So there should be a strong link between the two. The CDS market is all offshore, and I believe it is quite illiquid. Still, Pravin describes a fascinating relationship between the two. He has a striking picture in his article, where the red line is the CDS and the blue line is the stock price:

The stock price and the CDS time-series are both I(1). If I shift them to returns, and thus make them I(0), using the full dataset, I see a relationship where the stock price leads the CDS over a one-two day horizon. In my mind, this emphasises the interlinkages between markets: corporate bonds are tightly linked to the government bond yield curve, but when you focus on the credit risk of a corporate bond, it's tightly linked to equity risk. A position which is long corporate bond and short government bond is pure credit risk: this is what the credit derivatives are about and this is what the stock market is about.

What would be great is to have trading on all these instruments - interest rate derivatives, government bonds, corporate bonds, credit derivatives, equity, equity derivatives - by a unified set of participants with a unified system of markets. That's the `BCD Nexus' idea of the MIFC report, and it's very different from the silo system that we have in India today.