Capital Structure Arbitrage: Model Choice and Volatility Calibration

47 Pages Posted: 14 Jan 2007 Last revised: 16 Jul 2008

See all articles by Claus Bajlum

Claus Bajlum

Copenhagen Business School

Peter Tind Larsen

Aarhus University - School of Business and Social Sciences

Date Written: July 13, 2008

Abstract

When identifying relative value opportunities across credit and equity markets, the arbitrageur faces two major problems, namely positions based on model misspecification 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 traditional volatility from historical equity returns. However, relying on an implied volatility from equity options results in a substantial gain in strategy execution and highly significant excess returns - even when small gaps are exploited. The gain is largest in the speculative grade segment, and cannot be explained from systematic market risk factors. However, although the strategy may seem attractive at an aggregate level, positions on individual obligors can be very risky.

Keywords: credit default swaps, structural models, hedge funds, relative value trading

JEL Classification: G33, G13

Suggested Citation

Bajlum, Claus and Larsen, Peter Tind, Capital Structure Arbitrage: Model Choice and Volatility Calibration (July 13, 2008). Available at SSRN: https://ssrn.com/abstract=956839 or http://dx.doi.org/10.2139/ssrn.956839

Claus Bajlum

Copenhagen Business School ( email )

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

Peter Tind Larsen (Contact Author)

Aarhus University - School of Business and Social Sciences ( email )

Universitetsparken, bldg. 322
DK-8000 Aarhus C
Denmark
+45 89422139 (Phone)

HOME PAGE: http://www.econ.au.dk

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
1,271
Abstract Views
5,134
Rank
31,555
PlumX Metrics