YOUR KILLER EQUITIES INTERVIEW QUESTIONS: Are sovereign CDS spreads a leading or lagging indicator of equity volatility?

Here's the latest question sent in by site visitors who have attended equities interviews at investment banks. This question has allegedly been asked in equity derivatives trading interviews at Morgan Stanley. The answer has been suggested by the person who submitted the question (and is not being advocated by us). If you disagree with the answer, or have any superior alternative responses, please express your opinion in the comments box below.

THE QUESTION: Are sovereign CDS spreads a leading or lagging indicator of equity volatility?

THE SUGGESTED ANSWER:

Well, during the crisis they were clearly a leading indicator as CDS spreads blew out well in advance of equity volatility levels.

However in recent times they have not really been a leading or lagging indicator since peripheral European sovereign levels seem to continue to rise. Greek 5 year CDS levels are well in excess of 2,000 and Portugal and Ireland are on a continued upward trend, yet equity volatility levels have been low.

For example, although VIX has risen in the past week, it remains a lot lower than might be expected. This means that there has been somewhat of a breakdown in correlation between the two. Either investors have either shrugged off the issues of default in their equity allocation, or equity volatility levels are set to rocket soon.