Claremont McKenna College - Robert Day School of Economics and Finance
April 3, 2005
This paper examines the risk and return of the so-called capital structure arbitrage, which exploits the mispricing between a company's debt and equity. Specifically, a structural model connects a company's equity price with its credit default swap (CDS) spread. Based on the deviation of CDS market spreads from their theoretical counterparts, a convergence-type trading strategy is proposed and analyzed using 135,759 daily CDS spreads on 261 obligors. At the level of individual trades, the risk of the strategy arises when the arbitrageur shorts CDS and the market spread subsequently skyrockets, forcing the arbitrageur into early liquidation and engendering large losses. An equally-weighted portfolio of all trades produces Sharpe ratios similar to those of other fixed-income arbitrage strategies and hedge fund industry benchmarks. However, the monthly excess returns on this portfolio are not significantly correlated with either equity or bond market factors.