Rethinking Capital Structure Arbitrage

by Davide Avino of University of Reading, and
Emese Lazar of University of Reading

November 2012

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.

JEL Classification: G01, G11, G12, G14.

Keywords: credit spreads, price discovery, credit derivatives, information flow, convergence trading, financial crisis, limit of arbitrage.

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