Understanding the Role of VIX in Explaining Movements in Credit Spreads

Why does the VIX and market return explain changes in credit spreads? Existing literature suggests these factors proxy for macroeconomic risk. In this paper, we investigate an alternative hypothesis that the VIX in its role as a fear index impacts intermediary and arbitrageur capital, impacting spreads and resulting in decreased market integration across credit and equity markets. We document that hedging credit default swaps in the equity markets is surprisingly ineffective. On average, hedging reduces the RMSE reduces by 10% and the VaR by only 12%. However, a passive hedge kept in place over a period as long as a month is (multifold) more effective than dynamic daily hedging. We demonstrate that the VIX and market returns predict both the RMSE as well as the improvement in hedging effectiveness that occurs over time. Our results suggest that frictionless structural models of credit risk are of limited use in explaining changes in credit spreads because factors which are excluded from the pricing kernel have significant impact on credit spreads.