Rethinking Capital Structure Arbitrage: A Price Discovery Perspective
Journal of Alternative Investments, Vol. 22, pp. 75-91, 2020, https://jai.pm-research.com/content/22/4/75
Posted: 2 Jun 2012 Last revised: 24 May 2020
Date Written: May 23, 2019
The capital structure arbitrage strategy exploits the discrepancies between the credit default swap and equity markets. It assumes that both markets instantaneously react to new information, so it fails to take into account the lead-lag relationships between the prices in the two markets and their form of cointegration. Here we introduce three new alternative strategies that exploit the information provided by the time-varying price discovery of the equity and credit markets and the cointegration of the two markets. We implement the strategies for both US and European obligors and find that these outperform traditional arbitrage trading during the financial crisis. Furthermore, the returns of the new strategies have lower correlation with market returns than the standard capital structure arbitrage.
Keywords: credit spreads, price discovery, credit derivatives, information flow, convergence trading, financial crisis, limit of arbitrage
JEL Classification: G01, G11, G12, G14, G20, D8, D53
Suggested Citation: Suggested Citation