Rethinking Capital Structure Arbitrage

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 three 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. R-squared measures from a regression of strategies’ excess returns on market risk factors reveal that the new strategies’ returns have lower correlation with market returns than the standard capital structure arbitrage.