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Rethinking Capital Structure Arbitrage

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  • Avino, Davide
  • Lazar, Emese

Abstract

It is well known that the capital structure arbitrage strategy generated negative Sharpe ratios over the period 2005-2009. In this paper we introduce four new alternative strategies that, while still based on the discrepancy between the CDS market spread and its equity-implied spread, exploit the information provided by the time-varying price discovery of the equity and CDS markets. We implement the strategies for both US and European obligors and find that these outperform traditional arbitrage trading during the financial crisis. Moreover, the new strategies show higher Sharpe ratios when CDS and equity-implied spreads are cointegrated. The correlation of the new trading rules with hedge fund index returns is low or negative even during the crisis, which suggests that the new rules can be used for portfolio diversification at times when risk reduction is hard to achieve.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 42850.

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Date of creation: 14 Nov 2012
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Handle: RePEc:pra:mprapa:42850

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Related research

Keywords: credit spreads; price discovery; credit derivatives; information flow; convergence trading; financial crisis; limit of arbitrage;

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  1. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Jones, E Philip & Mason, Scott P & Rosenfeld, Eric, 1984. " Contingent Claims Analysis of Corporate Capital Structures: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 39(3), pages 611-25, July.
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  7. Juan Ignacio Pena & Santiago Forte, 2006. "CREDIT SPREADS: THEORY AND EVIDENCE ABOUT THE INFORMATION CONTENT OF STOCKS, BONDS AND CDSs," Business Economics Working Papers wb063310, Universidad Carlos III, Departamento de Economía de la Empresa.
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Cited by:
  1. Byström, Hans, 2013. "Stock Prices and Stock Return Volatilities Implied by the Credit Market," Working Papers 2013:25, Lund University, Department of Economics, revised 13 Sep 2013.

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