We show that the standard Granger causality test for assessing informational efficiency between financial markets is misspecified in the presence of market-microstructure noise, a pervasive feature of financial data. We propose a new test robust to such noise and apply it to credit markets, overturning several established results. The corporate bond market, not the CDS market, leads in price discovery; there is no evidence of insider trading in the CDS market; and bond transaction prices contain more timely information than quotes. The misspecification we document affects studies of information flows in many other financial markets.

Other author: Felix Akilles Lundén , Copenhagen Business School