“Higher risk yields higher return” is a backbone in financial analysis. The portfolio strategy is that this is true for credit risk as well, to measure credit risk this research uses the credit default swap (CDS) for 347 stocks included in the S&P 500. This strategy was able to outperform the S&P 500 portfolio over many of the periods by holding 2-4 stocks.

To pick the stock to be part of the portfolio, a system chooses the stock with the highest slope. The slope is the difference between 5-year and 1-year CDS price. Then the top ten portfolios were picked and converted into a new optimal portfolio; updates in the portfolio depends on the individual top ten portfolio strategies. Updates occurred on different periods; were new stocks were picked and sometimes holding already picked stocks. Much to do with infrequently updates of the stocks CDS prices, this strategy has, therefore, no problems with transaction costs.

An out-of-sample test showed significant evidence for similarities. To strengthen the evidence that a CDS strategy works in a different time-frame, this was tested using a test for out-of-sample, with maximizing on the periods 2010 to the end of 2015 and the holding this new strategy on the periods 2016-2019. The analysis of the out-of-sample test showed insignificant alpha and lower average returns than the full period test.

The CDS portfolio strategy generates positive and significant abnormal returns of 1.08%, considered to be a leveraged strategy to the S&P 500 portfolio and having monthly average returns of 3.78%. The Sharpe ratio was 1.05 compared to the S&P 500 portfolio of 0.72. However, in the out-of-sample test, the CDS portfolio were outperformed regarding a lower Sharpe ratio, which had much to do with firm-specific effects in mid of 2018 to the end of 2018. The out-of-sample portfolio showed similarities in behavior as the full period portfolio and strengthened the evidence of holding 2-4 stocks.

Analysts: Johan Andersson and Filip Franzén

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