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Capital Structure Arbitrage: Model Choice and Volatility Calibration

Author

Listed:
  • Bajlum, Claus

    (Department of Finance, Copenhagen Business School)

  • Tind Larsen, Peter

    (Department of Finance, Copenhagen Business School)

Abstract
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 trading strategy. In spite of dierences 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 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 signi cant 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. Although the strategy may seem attractive at an aggregate level, positions on individual obligors can be very risky.

Suggested Citation

  • Bajlum, Claus & Tind Larsen, Peter, 2007. "Capital Structure Arbitrage: Model Choice and Volatility Calibration," Working Papers 2007-230, Copenhagen Business School, Department of Finance.
    • Handle: RePEc:hhs:cbsfin:2007_230
    as

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    File URL: http://openarchive.cbs.dk/cbsweb/handle/10398/7196
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    Citations

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    Cited by:

    1. Sergio Mayordomo & Juan Ignacio Peña & Juan Romo, 2011. "A New Test of Statistical Arbitrage with Applications to Credit Derivatives Markets," CNMV Working Papers CNMV Working Papers no. 4, CNMV- Spanish Securities Markets Commission - Research and Statistics Department.
    2. Mayordomo, Sergio, 2009. "Are There Arbitrage Opportunities in Credit Derivatives Markets? A New Test and an Application to the Case of CDS and ASPs," DEE - Working Papers. Business Economics. WB wb096303, Universidad Carlos III de Madrid. Departamento de Economía de la Empresa.
    3. Shuichi Ohsaki & Akira Yamazaki, 2011. "Static Hedging Of Defaultable Contingent Claims: A Simple Hedging Scheme Across Equity And Credit Markets," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 14(02), pages 239-264.

    More about this item

    Keywords

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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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