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| Capital Structure Arbitrage: Model choice and volatility calibration by Claus Bajlum of Danmarks Nationalbank & Copenhagen Business School, and August 29, 2007 Abstract: When identifying relative value opportunities across credit and equity markets, the arbitrageur faces two major problems, namely positions based on model misspeci?cation and mismeasured inputs. Using credit default swap data, this paper addresses both concerns in a convergence-type trading strategy. In spite of differences in assumptions governing default and calibration, we ?find the exact structural model linking the markets second to timely key inputs. Studying an equally-weighted portfolio of all relative value positions, the excess returns are insignificant when based on a historical volatility. However, relying on an implied volatility from equity options results in highly significant excess returns. The gain is largest in the speculative grade segment, and cannot be explained from systematic market risk factors. Although the strategy may seem attractive at an aggregate level, positions on individual obligors can be very risky. JEL Classification: G11, G13, G33. Keywords: Credit default swaps, relative value trading, structural models. Books Referenced in this Paper: (what is this?)
Download paper (542K PDF) 52 pages Related reading: How Profitable Is Capital Structure Arbitrage?
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