When Risks and Market Inefficiency Shake Hands – An Empirical Analysis of Financial CDS

This paper examines the relation between absolute CDS premium and the market efficiency of financial institutions. We test the random-walk hypothesis on 3-years CDS data set using: Q-statistics portmanteau tests by Box and Pierce, variance ratio tests by Lo and MacKinlay, variance ratio tests using ranks and signs by Wright, and wild bootstrapping variance ratio tests by Kim. We find that CDSs with the highest means and the highest standard deviations tend to fail the random-walk hypothesis. These CDSs have the highest potential to trade in an inefficient market with the highst potential for speculation and market manipulation (i.e. by hedge funds). This inefficiency negates the original function of hedging. To reconstitute the function of hedging and to overcome a CDS market that is driven by speculation our research concludes that it is necessary to adopt further regulations for the CDS market.