We discuss a simple, exactly solvable model of stochastic stock dynamics that incorporates regime switching between healthy and distressed regimes. Using this model, which is analytically tractable, we discuss a way of extracting expected returns for stocks from realized CDS spreads, essentially, the CDS market sentiment about future stock returns. This alpha/signal could be useful in a cross-sectional (statistical arbitrage) context for equities trading.

Keywords: stock, credit default swap, CDS spread, healthy, distress, default, stochastic dynamics, statistical arbitrage, alpha, regime switching, expected return, market sentiment, equities trading, probability of default, drift, regression, Brownian motion, trading signal, transition density, recovery rate

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