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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.

Suggested Citation

  • Avino, Davide & Lazar, Emese, 2012. "Rethinking Capital Structure Arbitrage," MPRA Paper 42850, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:42850
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    File URL: https://mpra.ub.uni-muenchen.de/42850/2/MPRA_paper_42850.pdf
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    References listed on IDEAS

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    Cited by:

    1. Robert Goldberg, 2015. "A methodology for computing and comparing implied equity and corporate-debt Sharpe Ratios," Review of Quantitative Finance and Accounting, Springer, vol. 44(4), pages 733-754, May.
    2. Byström, Hans, 2013. "Stock Prices and Stock Return Volatilities Implied by the Credit Market," Working Papers 2013:25, Lund University, Department of Economics, revised 14 Feb 2014.

    More about this item

    Keywords

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

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G01 - Financial Economics - - General - - - Financial Crises

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