Evaluation of Capital Structure Arbitrage in the Equity-Credit Markets
Credit Default SwapsCapital Structure ArbitrageCreditgradesValue-at-RiskArbitrage TradingManagement of enterprisesFöretagsledningManagementBusiness and Economics
Purpose: The purpose of this thesis is to test for the existence of Capital Structure Arbitrage oppertunities in the equity-credit markets. Methodology: The mispricing of Credit Default Swap contracts are calculated and used as input in an Equity-Credit market trading strategy. The returns are then evaluated with a modified Value-at-Risk simulation. Theoretical perspectives: A Merton-based structural model, CreditGrades, is used for credit pricing and a mispricing-convergence trading-strategy between the credit and equity markets is implemented. Empirical foundation: Daily quotes for the Credit Default Swap spread of 37 European firms were collected for a period of two years, as well as equity-prices for the same period and the previous two years, used for model calibration. Conclusions: The trading shows a statistically significant total return of the Capital Structure Arbitrage trading strategy of 32,9%, compared to 10,8% with pure Credit Default Swap speculation. The equity-hedge of the strategy effectively lowers Value-at-Risk, and thus results in a higher return, which supports the argument for Capital Structure oppertunities. The results however, are very volatile, something that might suggest that the strategy chosen is closer to speculation than arbitrage.