Anatomize DOOM-CDS Linkage

In this paper, we exploit the divergence of the implied hazard rates derived from Deep Out-of-the-Money Put Options (DOOM) and Credit Default Swaps (CDS) in producing profitable trading strategies. We extend the work in Carr and Wu (2010) by decomposing the implied hazard rates into credit and illiquidity components. We find that the information based on the components refine the prediction of the convergence. We show that, after controlling for factors explaining the structural difference between the markets, both components converge overtime in these two markets. While the Benchmark strategy produces the largest total returns due to the large amount of trades, our component-refined strategies lead to greater mean return (by 2%) and beat the Benchmark by Sharpe ratio and Carhart alpha