Capital Structure

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 trad-

ing strategy. In spite of di¤erences in assumptions governing default and

calibration, we …nd 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 insigni…cant when based on a histor-

ical volatility. However, relying on an implied volatility from equity options

results in highly signi…cant excess returns. The gain is largest in the specu-

lative 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 classi…cations: G11, G13, G33

Keywords: Credit default swaps, relative value trading, structural modelsCapital structure arbitrage refers to trading strategies that take advantage of the

relative mispricing across di¤erent security classes traded on the same capital

structure. As the exponential growth in the credit default swap (CDS) market

has made credit much more tradable and traditional hedge fund strategies have

su¤ered declining returns (Skorecki (2004)), important questions arise for hedge

funds and proprietary trading desks. In particular, do credit and equity markets

ever diverge in opinion on the quality of an obligor? What is the risk and return of

exploiting divergent views in relative value strategies? Although trading strategies

founded in a lack of synchronicity between equity and credit markets have gained

huge popularity in recent years (Currie & Morris (2002) and Zuckerman (2005)),

the academic literature addressing capital structure arbitrage is very sparse.

This paper conducts a comprehensive analysis of the risk and return of capi-

tal structure arbitrage using