Regime dependent causality : equity and credit markets

We apply a Markov switching model to investigate the possibility of an asymmetric causal relationship between the volatility process inferred from the iTraxx CDS options market and the implied volatility from the stock index options market. We find strong evidence that the stock market leads the CDS market and the effect of the implied stock market volatility is more significant during the volatile regime. We also find that a large jump in the stock return, up or down, may indeed be followed by a regime shift.