Limited Arbitrage between Equity and Credit Markets

65 Pages Posted: 17 Mar 2009 Last revised: 22 Feb 2012

See all articles by Nikunj Kapadia

Nikunj Kapadia

University of Massachusetts Amherst - Department of Finance

Xiaoling Pu

Kent State University - Department of Finance

Date Written: Feb 20, 2012

Abstract

We document that short-horizon pricing discrepancies across firms' equity and credit markets are common and that an economically significant proportion of these are anomalous, indicating a lack of integration between the two markets. Proposing a statistical measure of market integration, we investigate whether equity-credit market integration is related to impediments to arbitrage. We find that time variation in integration across a firm's equity and credit markets is related to firm-specific impediments to arbitrage such as liquidity in equity and credit markets and idiosyncratic risk. Our evidence provides a potential resolution to the puzzle of why Merton model hedge ratios match empirically observed stock-bond elasticities (Schaefer and Strebulaev, 2008) and yet the model is limited in its ability to explain the integration between equity and credit markets (Collin-Dufresne, Goldstein, and Martin, 2001).

Keywords: limited arbitrage, credit default swap

JEL Classification: G10, G12, G14

Suggested Citation

Kapadia, Nikunj and Pu, Xiaoling, Limited Arbitrage between Equity and Credit Markets (Feb 20, 2012). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=1360542 or http://dx.doi.org/10.2139/ssrn.1360542

Nikunj Kapadia (Contact Author)

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States
413-545-5643 (Phone)
413-545-5600 (Fax)

HOME PAGE: http://www-unix.oit.umass.edu/~nkapadia/

Xiaoling Pu

Kent State University - Department of Finance ( email )

College of Business Administration
P.O. Box 5190
Kent, OH 44242-0001
United States

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