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| Yu, Fan, "How Profitable Is Capital Structure Arbitrage?", Financial Analysts Journal, Vol. 62, No. 5, (September/October 2006), pp. 47-62. Abstract: This paper examines the risk and return of the so-called "capital structure arbitrage," which exploits the mispricing between a company's credit default swap (CDS) spread and equity price. Using an industry benchmark model called "CreditGrades," I implement a convergence-type trading strategy with 135,759 daily CDS spreads on 261 obligors. At the level of individual trades, substantial losses can occur as a result of the low correlation between the CDS spread and the equity price. However, an equally-weighted portfolio of all trades produces Sharpe ratios similar to those of other fixed-income arbitrage strategies and hedge fund industry benchmarks. In particular, the monthly excess returns on this portfolio are not significantly correlated with either equity or bond market factors. Books Referenced in this Paper: (what is this?)
Related reading: Valuation of Capital Structure using Simulation Techniques |
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