Informed trading in the CDS and OTM put option markets

This paper investigates the role of liquidity in the price discovery process. Specifically, we focus on how informed traders straddle the credit default swap (CDS) and option markets, with OTM put options particularly, and how their choice where to trade depends on the relative liquidity in these markets. We employ daily data of the two most actively traded North American CDX In-vestment Grade and High Yield indexes from 2010 to 2018. Our empirical results show that relative liquidity is a key factor in where informed trading occurs in CDS and put option markets. Our results suggest that liquidity is the main factor that determines the leadership of the price discovery process between the two markets. When the CDS market is relatively illiquid, informed investors trade in the options market such as OTM put options.

Automated summary

This research investigates the role of liquidity in the price discovery process and focuses on how informed traders use CDS and option markets for trading, depending on the relative liquidity in these markets. The empirical results suggest that liquidity is a crucial factor in determining the location of informed trading and the leadership of the price discovery process between the two markets.