Organigrama funcional

Our results from the price discovery tests can be explained by one of two possible reasons. Informational efficiency could be driven either by the higher liquidity levels in the stock market or by the more savvy investors/traders in the CDS market. As the idea of this paper is to identify any changes in the CDS and stock market price discovery mechanism due to the financial sector meltdown, we focus on the post-crisis scenario results in our analysis.

Our general finding is that, since the start of the crisis, stocks have started contributing even more to the price discovery process. We therefore try to isolate some key factors that could impact informational efficiency in the two markets:

1) CDS Liquidity: With a higher level of liquidity, we would expect to see faster dissemination of information in this market. Given that the CDS instruments are traded over-the-market, there is little information available on their actual trading volumes. We use the Amihud and

Mendelson (1986) measure represented by the bid-ask spread as a proxy for liquidity.

The average bid-ask spread for our data increases from 5.35 bps in the pre-crisis period to 13.75 bps in the post-crisis period reflecting a decrease in liquidity in the overall CDS market - except for one firm where the bid-ask spread remains almost unchanged, we find a widening of spreads in all cases.

In a recent working paper, Dragon and Yan (2007) proxy CDS liquidity by a scaled measure as well i.e. the percentage spread (bid-ask spread divided by the mid spread). Using this we find that the scaled bid-ask spread decreases from 16.3% to 9.3% in the post-crisis period showing an increased liquidity situation in the post-crisis world.

To understand this contradiction between the two measures, we must consider actual CDS spread levels (i.e. the scaling factor) and find that while the average bid-ask spreads have increased, the increase in average CDS spreads has been from 52bps to 194 bps. This more than proportional increase in CDS spread levels results in a reduction in scaled bid-ask spread levels.

Given that the CDS market liquidity decreased during the crisis, especially given the AIG issues, the bid-ask spread measure makes more sense as a liquidity proxy and we use it in our paper.

2) Stock Volume Traded: In line with our focus on liquidity, we also look at the average level of trading activity in the stock market. An increase in the average trade volume in the post-crisis period may be able to explain the increased level of price efficiency in the stock markets. Our data shows that the average daily stock trading volume increased from around 485,000 shares in the pre-crisis period to 1.05 million shares in the post-crisis world with 143 firms registering an increase and 55 companies showing a decline in traded volume. As a result, we can conclude that, unlike in the CDS market, liquidity in the stock market has increased during the post-crisis period.

2) Analyst estimates: As an additional measure, we consider analyst coverage of the firms in our database. Research firms assign analysts to a firm depending on the level of public interest or investment potential in that company. Therefore an increase in the number of analysts covering a firm can be used as a proxy for heightened investor awareness about or interest in a firm and would lead to faster absorption of firm related news.

Given the higher level of trading volume in the post-crisis period, we expect to see an increase in the number of analysts covering these firms. However, we find that the average number of analysts covering the firms decreases from 14.6 in the pre-crisis scenario to 13.6 in the post- crisis world with only 62 of the 198 firms showing an increase in analyst coverage (we could not find analyst coverage data for 3 firms). The declining analyst coverage should be seen in the backdrop of the financial crisis where significant layoffs occurred in financial institutions, including equity research units.

We therefore use these three measures of liquidity and information coverage to understand the change in price discovery dynamics since the start of the financial crisis.

Looking at the firms where the CDS market leads, we find a widening of bid-ask spreads from 6 bps to 27 bps in all cases (Table 4.9) reflecting lower CDS liquidity for these firms. We also find a decrease in analyst coverage in 16 of the 24 cases while traded share volumes increase in 16 cases.

Focusing on the 144 cases where the stock markets lead the CDS market, we find that average bid-ask spreads increase from 6 bps to 15 bps; an increase in almost all cases. We also find an increase in the traded share volumes and a small decline in analyst coverage.

We now consider the CDS or risk levels as an alternative explanation for our price discovery results. We find that CDS levels (Table 4.7) for firms where the CDS market leads, have increased from an average of 89 bps to 411 bps while firms where price leads have also increased but only increased from 59 bps to 211 bps.

The above shows that the stock market liquidity is primarily driving price discovery while only in instances where risk levels are very high, price discovery occurs in the CDS markets. This is in line with findings from previous studies and our paper finds that despite the upheaval in the financial sector, price discovery dynamics have remained unchanged.