Capital Structure Arbitrage Research Articles

An Exact Structural Model for Evaluating Credit Default Swaps: Theory and Empirical Evidence

Using structural models for credit default swaps has been difficult. Existing models all adopt shortcuts as approximations. In this article, we provide an accurate and efficient solution to the price of the credit default swap. The main result is a Theorem in section 2. In an empirical study, we show how our model can properly capture credit default swap exposure to interest rate volatility and asset volatility. Furthermore, we apply the new model to study (1) the interactions among market, credit, and interest risks; (2) the consistency with the reduced-form credit risk models; and (3) implications to capital structure arbitrage.

Informed trading or liquidity trading: a theoretical formulation

This paper provides theoretical formulations of informed trading contrasted with liquidity trading. Informed trading occurs when traders flock to purchase or sell securities, based upon private information. In contrast, liquidity traders purchase or sell securities for their own inventory. Informed traders purchase in large volume over very short periods of time, with a definite direction of price movement. Liquidity trading consists of unlimited market entry of traders, reducing profit per trader, along with a long time period of investment in which the direction of price movement is uncertain, diminishing gains. This paper presents optimal trade prices for informed traders prior to stock mergers, whereupon traders have been observed short selling the acquirer stock, using the proceeds to purchase target stock, or to purchase put options. A capital structure arbitrage strategy is used for liquidity traders, with the trader purchasing or selling bonds at trade prices influenced by the market maker's prices. Proceeds from this strategy may be used to purchase equities.

Practical Applications of Rethinking Capital Structure Arbitrage: A Price Discovery Perspective

Practical Applications In Rethinking Capital Structure Arbitrage: A Price Discovery Perspective, published in the Spring 2020 issue of The Journal of Alternative Investments, Davide Avino (University of Liverpool) Emese Lazar (University of Reading) create a price discovery filter for trades in a capital structure arbitrage strategy (CSA), and two similar but unhedged trading strategies. They show that, overall, these three new approaches to exploiting mispricing between credit default swaps and equity markets outperform the typical CSA approach. The standard base-case CSA strategy uses a trading trigger but not a price discovery filter. The relative performance of the strategies varies, however, depending on whether they are traded in a calm period or a crisis period; are trading investment or speculative-grade obligors; and are trading US or European obligors. Interestingly, the unhedged strategies outperform the hedged strategies during crisis periods. Of the strategies examined, the best-performing one relies on a more accurate form of the cointegrated relationship between the credit default swap and equity markets than the other strategies do.

Rethinking Capital Structure Arbitrage: A Price Discovery Perspective

The capital structure arbitrage strategy exploits the discrepancies between the credit default swap and equity markets. It assumes that both markets instantaneously react to new information, so it fails to take into account the lead–lag relationships between the prices in the two markets and their form of cointegration. The authors introduce three new alternative strategies that exploit the information provided by the time-varying price discovery of the equity and credit markets and the cointegration of the two markets. The authors implement the strategies for US and European obligors and find that these outperform traditional arbitrage trading during the financial crisis. Furthermore, the returns of the new strategies have a lower correlation with market returns than the standard capital structure arbitrage. TOPICS:Derivatives, financial crises and financial market history Key Findings • We introduce three new capital structure arbitrage strategies. • The new trading strategies incorporate price discovery signals of both equity and credit markets. • The trading strategies we introduce outperform the standard capital structure arbitrage during the financial crisis of 2007–2008.

Capital Structure Arbitrage under a Risk-Neutral Calibration

By reinterpreting the calibration of structural models, a reassessment of the importance of the input variables is undertaken. The analysis shows that volatility is the key parameter to any calibration exercise, by several orders of magnitude. To maximize the sensitivity to volatility, a simple formulation of Merton’s model is proposed that employs deep out-of-the-money option implied volatilities. The methodology also eliminates the use of historic data to specify the default barrier, thereby leading to a full risk-neutral calibration. Subsequently, a new technique for identifying and hedging capital structure arbitrage opportunities is illustrated. The approach seeks to hedge the volatility risk, or vega, as opposed to the exposure from the underlying equity itself, or delta. The results question the efficacy of the common arbitrage strategy of only executing the delta hedge.

Revisiting Structural Modeling of Credit Risk—Evidence from the Credit Default Swap (CDS) Market

The ground-breaking Black-Scholes-Merton model has brought about a generation of derivative pricing models that have been successfully applied in the financial industry. It has been a long standing puzzle that the structural models of credit risk, as an application of the same modeling paradigm, do not perform well empirically. We argue that the ability to accurately compute and dynamically update hedge ratios to facilitate a capital structure arbitrage is a distinctive strength of the Black-Scholes-Merton’s modeling paradigm which could be utilized in credit risk models as well. Our evidence is economically significant: We improve the implementation of a simple structural model so that it is more suitable for our application and then devise a simple capital structure arbitrage strategy based on the model. We show that the trading strategy persistently produced substantial risk-adjusted profit.

Stock Prices and Stock Return Volatilities Impliedby the Credit Market

In this article, the author compares equity and credit investors’ opinions on price formation in the equity market. More exactly, he inverts the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for companies in the DJIA index. The credit-implied stock prices often deviate significantly from actual stock prices over the long term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA. In an attempt to demonstrate potential applications of credit-implied stock prices, the author constructs simple “capital structure arbitrage” trading strategies based on past credit-implied prices. These strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. The author demonstrates how an alternative credit-based “fear gauge,” comparable to the CBOE VIX but emanating from the credit market, can be constructed using the credit-implied volatilities. He calls this implied volatility index the Credit-Implied Volatility Index (CIVX). Finally, a plot of the entire term structure of implied volatilities demonstrates a distinct maturity volatility skew.

Stock Prices and Stock Return Volatilities Implied by the Credit Market

In this paper we compare equity- and credit investors’ opinions on the price formation in the equity market. More exactly, we invert the CreditGrades model in order to back out credit-implied stock prices and stock return volatilities from credit default swap spreads for the firms in the DJIA index. The creditimplied stock prices often deviate significantly from actual stock prices over the longer term. Meanwhile, their day-to-day movements are significantly correlated with actual stock returns for most firms in the DJIA index. In an attempt to demonstrate potential applications of credit-implied stock prices we construct simple “capital structure arbitrage” trading strategies based on past credit-implied prices. Our strategies only require the buying and selling of stocks and differ from traditional cross-capital structure strategies by being suitable for retail investors and other investors without access to the credit derivatives market. The credit-implied volatilities, in turn, behave rather similarly to observed stock market volatilities but without any ghost effects. We demonstrate how an alternative credit-based “fear gauge”, comparable to the VIX index but emanating from the credit market, can be constructed using the credit-implied volatilities. We call this implied volatility index the Credit-Implied Volatility Index (CIVX) index. Finally, a plot of the entire term-structure of implied volatilities demonstrates a distinct maturity volatility skew.

Sentiment and Corporate Bond Valuations before and after the Onset of the Credit Crisis

Stock market sentiment is an important driver of corporate bond valuations. Using transactions from the Trading and Compliance Engine (TRACE), the authors find that sentiment is negatively related to bond yield spreads, with the impact being stronger after the onset of the recent financial crisis. The negative effect of sentiment on yields is stronger when fundamental risk and liquidity frictions are higher, which points to a direct role of sentiment in the bond market whereby rational bond investors are unable in these high-risk/high-friction scenarios to correct the mispricing generated by other bond investors. The authors also find that the sentiment effect is stronger when the returns to capital structure arbitrage are higher, suggesting that sentiment also spills over to the bond market through the activity of invesinvestors dedicated to correcting relative stock and bond value mispricings within the same firm. They further provide evidence that after the onset of the crisis, sentiment also helps explain the extent to which the corporate bond market and the equity market are integrated.

Revisiting the Credit–Equity Power Relationship

The credit–equity power relationship is an empirical parameterization of credit default swap (CDS) spreads by stock prices that is characterized by its credit–equity elasticity parameter and that is popular among practitioners involved in capital structure arbitrage quantitative strategies. This article provides a theoretical foundation for the credit–equity elasticity involving the financial leverage of the company. After underscoring the weaknesses of a calibrating approach relying exclusively on econometrics, the article highlights the practical relevance of this fundamental result in terms of credit–equity calibration.

Capital Structure Arbitrage Revisited

We study risk and return properties of capital structure arbitrage strategies aiming to profit from temporal mispricing between equity and credit default swaps (CDSs) of companies. We find that capital structure arbitrage provides an attractive annualized return of 24.35% on invested capital. The arbitrage returns are higher for lower rated companies and surprisingly they are also higher for more liquid companies with larger CDS trading volumes. We find that the number of open arbitrage trades can at times cluster and in our sample the concentration of trades occurs when they are most profitable, which highlights the issue of capital allocation. Constructing weekly return indices of capital structure arbitrage, we find that no more than 15% of the returns is explained by common risk factors.

Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage

In a naked credit default swap (CDS) position, a party pays an income stream to a seller of protection to swap away default risk on an underlying defaultable security without actually holding this reference instrument. Using mark-to-market returns on a large cross section of CDS positions, held independent from their reference entity, we implement a novel test to establish whether their inclusion in an optimised portfolio is replicable by a large set of alternative assets. Overall, we find significant excess returns of over 28% per annum against an optimised benchmark, we speculate that it is these characteristics that could be driving a bubble in the CDS market.

Evaluation of conducting capital structure arbitrage using the multi-period extended Geske–Johnson model

This study utilizes a multi-period structural model developed by Chen and Yeh (Pricing credit default swaps with the extended Geske–Johnson Model. Working paper, 2006), which extends the Geske and Johnson (J Financ Quant Anal 19:231–232, 1984) compound option model to evaluate the performance of capital structure arbitrage. In the paper, first of all, we predict the default probability for each firm using the multi-period Geske–Johnson model that assumes endogenous default barriers. Second, based on the arbitrage performance of 369 North American obligators from 2004 to 2008, we find that the extended Geske–Johnson model is more suitable than the CreditGrades model for exploiting the mispricing between equity prices and credit default swap spreads. Finally, the Geske–Johnson model also performs well in extreme market condition, such as the financial crisis around 2008.

AN IMPLIED VOLATILITY MODEL DETERMINED BY CREDIT DEFAULT SWAPS

In this paper we propose a diffusion model relating the stock price dynamics to the CDS spread dynamics of a company by assuming a linear relationship between instantaneous stock volatility and CDS spread. To value contingent claims under this model we apply a finite elements discretization to the associated pricing partial differential equation. A robust calibration strategy is presented and numerical examples are studied to validate the model assumptions. Besides option pricing, we discuss further applications which are e.g. the identification of market situations allowing volatility and capital structure arbitrage.

Hedge funds, CDOs and the financial crisis: An empirical investigation of the “Magnetar trade”

The so called Magnetar trade (a kind of capital structure arbitrage on the US housing market, using CDS and synthetic CDOs, and exploiting rating-dependent mispricing of risk) has gained a high publicity due to a Pulitzer Prize awarded media story from two journalists of ProPublica (an online news outlet). The story essentially claimed that the mortgage investment strategy of the hedge fund Magnetar during the period between 2006 and mid 2007 was based on a desire to construct CDO deals with riskier assets so that they could place bets that portions of their own deals would fail. This paper provides several pieces of evidence in line with the argument that tranches from Magnetar-sponsored CDOs present overly risky investments. However, investors and rating agencies appear to have adjusted their required spread levels and ratings to reflect this higher riskiness, at least to some extent.

Rethinking Capital Structure Arbitrage

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.

Capital Structure Arbitrage: An Analysis of the Australian CDS Market

This study investigates the ability of the CreditGrades model to estimate Credit Default Swap (CDS) spreads by comparing the difference between model and market spreads using a number of volatility inputs. We then develop a convergence style capital structure arbitrage trading strategy and test its profitability in the Australian CDS market before and during the financial crisis. We conclude that model performance before the crisis is consistent with previous literature, yet model and market spreads diverge considerably throughout the more volatile period. Although forward-looking option-implied volatility inputs produce inferior fit compared to long-term historical volatility inputs, they are more correlated with medium term changes in market spreads, and thus significantly more profitable within the trading strategy during the volatile period. While trades using all volatility inputs are highly risky at both the individual obligator and the iTraxx Australia Index level, those based on implied volatility are found to be highly profitable, on average, after transaction costs are taken into account. The strategy is significantly less risky when positions are combined into an equally weighted index of arbitrage trades. Financial firms, with which structural models have traditionally struggled, are included in the sample by way of a model calibration procedure, and their inclusion does not decrease the accuracy of the model, nor the profitability of the trading strategy.

Empirical analysis and calibration of the CEV process for pricing equity default swaps

Equity Default Swaps (EDSs) are credit-like instruments that were first introduced in 2003. EDSs are deep out of the money digital put options that pay out a fixed amount (recovery rate) upon the stock price hitting a pre-set low barrier. The premium is paid out as contingent quarterly payments similar to Credit Default Swaps (CDSs). EDSs initially soared in volume as investors used them in capital structure arbitrage strategies involving the simultaneous buying and selling of EDS contracts, as spreads on EDSs were several multiples of CDS spreads. However, the contracts diminished in volume as CDS contracts took over. With the recent financial turmoil in the credit derivatives market, some attention has turned from CDS and their associated structured correlation products such as Nth-to-default basket and synthetic Collateralized Debt Obligations (CDOs) as CDS markets tend to be opaque and difficult to price. In addition, default correlations are not directly observable and recoveries are stochastic, making pricing and modelling difficult. As against this, the underlying stock prices in EDS are directly observable and the correlation is also directly observable. The EDS may therefore return to the credit fold and may be a complement to the CDS market. In this paper, we examine the pricing of CDSs using the CEV process and calibrate the CEV process to actual observed market prices for EDS; we then draw conclusions on the CEV process, the relationship between stock prices and volatility, and the relationship between CDS and EDS prices.

On the Relationship Between Asian Credit Default Swap and Equity Markets

When extended to sovereign issuers, the Merton‐type structural model suggests a negative relationship between sovereign credit default swap (CDS) spreads and stock prices. In practice, capital structure arbitrage that exploits such relationships should foster the integration of CDS and the stock market and improve price discovery. This paper studies the dynamic relationship between sovereign CDS spreads and stock prices for seven Asian countries for the period from January 2001 to February 2007. We find a strong negative correlation between the CDS spread and the stock index for most Asian countries. A long‐run equilibrium price relationship is found for China, Korea, and Thailand. The limited integration in other countries may arise from market frictions and model applicability. In terms of price discovery, CDS markets play a leading role in five out of seven countries. Therefore, equity investors should span the CDS market for incremental information. The stock market has a feedback effect for two countries and dominates price discovery for only one country.

How Efficient are Credit Default Swap Markets? An Empirical Study of Capital Structure Arbitrage Based on Structural Pricing Models

We investigate the efficiency of the credit default swap (CDS) market via the profitability and risk of capital structure arbitrage strategies based on observed mispricing in the CDS market over the years 2002 to 2006. We find that the CDS market has been inefficient in our observation period although this inefficiency declined over time. For this purpose, we calculate CDS premiums by means of the CreditGrades (2002) model and the models of Leland and Toft (1996) and Zhou (2001) and apply those within a capital structure arbitrage context for a dataset covering more than 800,000 observations. Our results indicate that structural credit risk models can adequately replicate market spreads but still produce significant positive arbitrage returns within our strategy. This also holds when transaction costs are incorporated. Accounting for risk via the Sharpe ratio reveals that the CDS market was inefficient at the beginning of our sample period but became efficient in the years 2004/2005 consistent with soaring trading volumes and the introduction of CDS index trading at this time. We are also able to show that the mathematically more advanced Leland and Toft and Zhou models provide larger arbitrage returns within our strategy. Considering rating classes, the arbitrage returns increase as obligors become riskier, in line with standard investment theory.