Capital Structure
Essay by Zomby • September 30, 2011 • Essay • 462 Words (2 Pages) • 1,827 Views
When identifying relative value opportunities across credit and equity
markets, the arbitrageur faces two major problems, namely positions based
on model misspeci cation and mismeasured inputs. Using credit default
swap data, this paper addresses both concerns in a convergence-type trad-
ing strategy. In spite of di¤erences in assumptions governing default and
calibration, we nd the exact structural model linking the markets second
to timely key inputs. Studying an equally-weighted portfolio of all relative
value positions, the excess returns are insigni cant when based on a histor-
ical volatility. However, relying on an implied volatility from equity options
results in highly signi cant excess returns. The gain is largest in the specu-
lative grade segment, and cannot be explained from systematic market risk
factors. Although the strategy may seem attractive at an aggregate level,
positions on individual obligors can be very risky.
JEL classi cations: G11, G13, G33
Keywords: Credit default swaps, relative value trading, structural modelsCapital structure arbitrage refers to trading strategies that take advantage of the
relative mispricing across di¤erent security classes traded on the same capital
structure. As the exponential growth in the credit default swap (CDS) market
has made credit much more tradable and traditional hedge fund strategies have
su¤ered declining returns (Skorecki (2004)), important questions arise for hedge
funds and proprietary trading desks. In particular, do credit and equity markets
ever diverge in opinion on the quality of an obligor? What is the risk and return of
exploiting divergent views in relative value strategies? Although trading strategies
founded in a lack of synchronicity between equity and credit markets have gained
huge popularity in recent years (Currie & Morris (2002) and Zuckerman (2005)),
the academic literature addressing capital structure arbitrage is very sparse.
This paper conducts a comprehensive analysis of the risk and return of capi-
tal structure arbitrage using
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