On Betas and Credit Spreads

This was a little reasearch endeavor I cooked up after looking at credit spreads with the VIX, and after looking at similar exercises done by others that I expounded on here.

I’m very much fascinated by the interplay between debt and equity, because they are the yin and yang of finance. Symbiotic, yet independent. But I think anyone who invests in one asset class but ignores a set of signals given off by the other does so at their own peril.

The basis of beta is the CAPM model, which is presented below:

All this equation is telling us is the return of a stock is equal to the sum of the risk-free rate (Treasuries) and the product of the stock’s beta and the market risk premium, where we define the market risk premium as the difference between the market’s expected return and the risk-free rate. The beta coefficient is interpreted as a measure of volatility where betas larger than 1 suggest a stock is more volatile and betas less than 1 indicate less volatility. So just as the VIX measured inherent volatility in stocks via the options market (and fit the data pretty well), beta measures that volatility based on returns of both the market and the individual stock.

But in this case, I was calculating the beta of an index so I needed two indices, not one as normally you would be calculating beta for an individual stock and it would be derived via regression against an index.

I published my results here. Needless to say, they came up short because there was no discernible relationship to be found between the betas that were calculated and credit spreads over Treasuries. But like the VIX, Aaa spreads had a better fit than Baa spreads. I think the data was at too high a level and I may have needed more granularity by looking at one stock or a handful of stocks against an index, but I was looking for existence of a broader relationship, which I didn’t find here.

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