Rethinking Capital Structure Arbitrage: A Price Discovery Perspective

Abstract

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. The authors 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. The authors implement the strategies for US and European obligors and find that these outperform traditional arbitrage trading during the financial crisis. Furthermore, the returns of the new strategies have a lower correlation with market returns than the standard capital structure arbitrage. TOPICS: Derivatives, financial crises and financial market history Key Findings • We introduce three new capital structure arbitrage strategies. • The new trading strategies incorporate price discovery signals of both equity and credit markets. • The trading strategies we introduce outperform the standard capital structure arbitrage during the financial crisis of 2007–2008.