The capital structure arbitrage strategy exploits the discrepancies between the credit default swap and equity markets. ��dS������$�\��{ “Capital Structure Arbitrage” Using a non-Gaussian approach MS&E 444 Investment Practice Project Report by Ramakrishnan Chirayathumadom Ronnie Zachariah George Venkateshwarlu Balla Dhiraj Bhagchandka Neeraj Shah Kunal Shah . e':]VH����GD��Mo 0000017684 00000 n ;4���u]N)$��(��m�0��M�c�9��,��m�9�D6ϼ_$��G�HB��b�\'��E&Wt����$��>�}n���)ϺD; The Arbitrage Pricing Theory (APT) was developed primarily by Ross (1976a, 1976b). Capital structure arbitrage refers to trading strategies that take advantage of the relative mispricing across different security classes issued from the same company's capital structure. 0000036503 00000 n ∏ Higher risk tends to lower a stock price, but a higher expected return raises it. Chapter 8 contains new evidence on option pricing. Capital Structure represents the mix of claims against a firm’s assets and free cash flow Some characteristics of financial claims Payoff structure (e.g. 0000044522 00000 n startxref 0000036343 00000 n g Visockis (2011) calculates CDS premiums using two structural models, namely, the Merton model and the CreditGrades model. 1 Rethinking Capital Structure Arbitrage Davide Avino and Emese Lazar* ICMA Centre, University of Reading, Henley School of Business, PO Box 242 RG6 6BA, UK Current version: November 2012 … In this strategy, there is buying undervalued securities and selling of the same company's overvalued securities. 0000034296 00000 n 0000000016 00000 n 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. Investors using the strategy will spot such a disparity and then buy or sell assets based on the logical assumption that the market will correct the disparity. Joost Driessen Date: 2011/04/28 Abstract This paper examines the risk and return of the so-called “capital structure arbitrage”, which exploits the mispricing between the company’s debt and equity. x�b```�FV�&``c`g`a������`��� �!�"l�٪YO���+r��c��~�};[(g�"�X�k�7X_�����ٳc�����Հ9�łe-�,�6��,B��7l�4ﻙ�g1�C�C�щ#�M!���Й#�'�Ƀ��0�#�Dhh(���Xy8. The paper explains this phenomenon. capital structure arbitrage could vary with model choice and indicated that model misspecification should have a significant effect on the gap between the market and model spreads. ��� *�+�������UX��P��Y�T���bW �k%L� �����#(((������ 0� ��` OU Q����Tʄ���DFA�)@��� b��TP1[d@�070��A�06 � kq�k ��,�JFA�F���N�d&%�p0)A�����P�`��� �!��@ͬ4���e�2��bU���������a������@5��N1p1z1d3nc(a����A�A�aY�}�N�MK�9:8'0�r&1� $1L�r���P �? It is the mix of different sources of long term funds such as equity shares , preference shares , long term debt , retained earnings etc. ARBITRAGE PROCESS - MM HYPOTHESISCAPITAL STRUCTURE THEORIES 0000030692 00000 n Capital structure arbitrage involves taking long and short positions in di fferent financial in-struments of a company’s capital structure, particularly between a company’s debt and equity products. 0000002593 00000 n �>Q2yeH��ūΫ�j��p�L��qn���F'VN��n�gIli�:Y;�e�M-L*��L&�YOM�1Plv�6�Y��!tTp��;f��g����p ,��r����uiub֞������J(�d+� As outlined in [9], the sensitivity to volatility, or vega, can be several orders of magnitude greater than the delta. 277 24 Capital Structure Policy involves a trade-off between risk and return 1) Using more debt raises the riskiness of the firm’s earnings stream. Capital structure in corporate finance is the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. This chapter is organised as follows: Section 2.2 provides a detailed justification on why capital structure matters. :��%!రQ� f�b�.n]�Z��Ք��B���q 6^M���5ᄠ�z��F�5D]6f�����q�����2�kq�Y^ ��)*6k^�h ț�y��+�QH�Z���-Yw �x�,��O�[䴐(��H �j���>���b�a7&%�)2q?�*�xD��J%@�P�h���=�Lf�a@ ?��\b���ԓ���T8��-c� t�B@+H�|�= N���(u��7��BD��7\�P�:�9 h��@%B��g��Vz&���Hh�rJZ�4 0000053828 00000 n Capital structure arbitrage is an investment strategy that seeks to take advantage of disparities between different equities and debt products issued by the same company. Capital structure arbitrage has lately become popular among hedge funds and bank proprietary trading desks. 0000056047 00000 n The results of the Merton model show that average monthly capital structure arbitrage … 0000020024 00000 n trailer << /Size 160 /Info 143 0 R /Root 146 0 R /Prev 369422 /ID[<10c987087b6a248bfb597ab36040f931><6bd417ae86128a5babb33ed8363a4f45>] >> startxref 0 %%EOF 146 0 obj << /Type /Catalog /Pages 139 0 R /Metadata 144 0 R >> endobj 158 0 obj << /S 974 /Filter /FlateDecode /Length 159 0 R >> stream Capital structure arbitrage (CSA) is a convergence trade strategy that is designed to ex-ploit the divergence in rm value as depicted by its debt and equity securities. Chapter 18 is completely new. 0000031474 00000 n 0000017073 00000 n literature review on the Capital Asset Pricing Model and the Arbitrage Pricing Model. Some traders have even touted it as the finext big thingfl or fithe hottest strategyfl in the arbitrage community. The materials on capital structure (Chapters 13 and 14) and on dividend policy (Chapters 15 and 16) have been completely rewritten to summarize the latest thinking in these rapidly changing areas of research. 0000001861 00000 n However, the theorem is still studied and taught, it tells us something important and that is, capital structure matters because one or more of the assumption is violated. SpeciÞcally, a structural model connects a company s equity price with its credit default swap (CDS) spread. GD The theorem tells where to look for making a decision of optimal capital structure and how optimal capital structure will be affected by those assumptions. 0000001982 00000 n Many investors believe that the stochastic returns of capital assets are consistent with a factor structure. It’s based on the assumption that there is a relationship between movements in equities and bonds. The fragile capital structure of hedge funds and the limits to arbitrage Xuewen Liuy Antonio S. Mello HKUST Wisconsin School of Business Forthcoming in Journal of Financial Economics Abstract During a –nancial crisis, when investors are most in need of liquidity and accurate prices, hedge funds cut their arbitrage positions and hoard cash. 0000002744 00000 n That is, firm value is independent of its capital structure. ����&b. The Arbitrage Pricing Model (AP) is a famous model used to determine the factors such as market portfolio which influences expected returns on individual asset prices in the financial markets. However, all studies published to date only consider delta-hedging or trading the underlying equity itself against the CDS. ����MdO��Ԗp�C��)�&��۶.�����x:�h�K��� ������B�}�0-b�1t*|)Pfv^S��HBo{���يEl9�̜�Sd�۶����ު��a4��8��2���s:�$Q|�RjtES����1��f�B�p�����f�(2ǹ�W^��X~QNB�G�+Р�g� �4���� W 2ޝ��f|�r9W��\O��+�1� Capital Structure Arbitrage Ričardas Visockis ANR: 98.66.43 MSc Investment Analysis UvT Master Thesis Supervisor: Prof.dr. Then the total market value of the firm, which is the same as the sum of the market values of the items on the right- hand side of the balance sheet (that is, its debt and equity), is not affected by how it is financed. Section 7 contains additional robustness checks. endstream endobj 159 0 obj 809 endobj 147 0 obj << /Type /Page /Parent 138 0 R /Resources 148 0 R /Contents 156 0 R /MediaBox [ 0 0 612 792 ] /CropBox [ 0 0 612 792 ] /Rotate 0 >> endobj 148 0 obj << /ProcSet [ /PDF /Text ] /Font << /TT2 149 0 R /TT3 153 0 R >> /ExtGState << /GS1 157 0 R >> /ColorSpace << /Cs5 154 0 R >> >> endobj 149 0 obj << /Type /Font /Subtype /TrueType /FirstChar 36 /LastChar 151 /Widths [ 500 833 778 0 333 333 0 0 250 333 250 278 500 500 500 500 500 500 500 500 500 500 278 278 0 0 0 444 921 722 667 667 722 611 556 722 722 333 389 722 611 889 722 722 556 722 667 556 611 722 722 944 722 722 611 333 0 333 0 0 0 444 500 444 500 444 333 500 500 278 278 500 278 778 500 500 500 500 333 389 278 500 500 722 500 500 444 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 333 444 444 0 0 1000 ] /BaseFont /LKNLIP+TimesNewRoman /FontDescriptor 150 0 R >> endobj 150 0 obj << /Type /FontDescriptor /Ascent 891 /CapHeight 656 /Descent -216 /Flags 6 /FontBBox [ -568 -307 2000 1007 ] /FontName /LKNLIP+TimesNewRoman /ItalicAngle 0 /StemV 94 /XHeight 0 /FontFile2 151 0 R >> endobj 151 0 obj << /Filter /FlateDecode /Length 41686 /Length1 65824 >> stream 2 Capital Structure Arbitrage Strategies: Models, Practice and Empirical Evidence - Oliver Berndt and Bruno Stephan Veras de Melo, November 2003, Lausanne, Switzerland . 0 0000030857 00000 n Section 2.3 discusses the principal theories of capital structure, namely, trade-off, agency, signalling, pecking order and contracting cost theories. 0000054240 00000 n 277 0 obj <> endobj capital structure arbitrage. It refers to the make up of a firm's capitalisation. Typically, mispricing opportunities arise between equity-linked and debt-linked securities. Capital structure arbitrage refers to trading strategies that take advantage of the relative mispricing across di⁄erent security classes traded on the same capital structure. t�����=6�Y!�9��Q��������n�W0}fYφ��~4�ɟ��Ŷ��7�_C�o9&�]�|��u01��. 0000001623 00000 n The basic idea behind the strategy is to go long one security in a company’s capital structure while at the same time going short another security in the same company’s capital structure. This project Capital structure arbitrage is a class of strategies used by market participants such as credit hedge funds and certain banks. 0000031281 00000 n 2 Anatomy of the Trading Strategy This section dissects the anatomy of capital structure arbitrage. 0000020497 00000 n 0000002504 00000 n %%EOF 0000001955 00000 n 2.1.2 Layout of this chapter . 0000000651 00000 n 2) However, a higher debt ration generally leads to a higher expected rate of return. It is a one-period model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. 42850, posted 28 Nov 2012 13:15 UTC. Capital structure arbitrage refers to the practice of exploiting relative pricing inefficiencies in the market by taking long and short positions across different instruments and asset classes of the capital structure of the same firm. 0000002375 00000 n PDF | After the turn of the millennium, a strategy called capital structure arbitrage started to gain interest among academics and practitioners. It is well known that the capital structure arbitrage strategy generated negative Sharpe ratios over the period 2005-2009. In this paper we introduce four new alternative strategies that, while still based on the discrepancy between the CDS market spread and its equity-implied spread, exploit the information provided by the time-varying price discovery of the equity and CDS markets. ii ABSTRACT In 1974, Robert Merton proposed a model for assessing the credit risk of a company by characterizing the company’s equity as a call option on its … Rethinking Capital Structure Arbitrage Avino, Davide and Lazar, Emese 14 November 2012 Online at https://mpra.ub.uni-muenchen.de/42850/ MPRA Paper No. In 1974 Robert Merton came up with his equity-based model for valuing debt products. 0000002248 00000 n 0000001803 00000 n This paper examines the risk and return of the so-called capital structure arbitrage, which exploits the mispricing between a company s debt and equity. 0000002515 00000 n 0000031155 00000 n 0000053658 00000 n 145 0 obj << /Linearized 1 /O 147 /H [ 727 918 ] /L 372452 /E 56278 /N 38 /T 369433 >> endobj xref 145 15 0000000016 00000 n Due to the rapid growth in the credit default swap (CDS) market, increasingly more CSA traders have switched from corporate bonds to CDS contracts to capture transitory mispricing between equity and debt markets. trailer M�d�v0뀒{�����IoM�8[��в�T��i� =�6�d�bQ8��n51��7�����2����x�(�4 Unit Trust of India etc., i.e., they do not encourage personal leverage. Compared with other fixed-income arbitrage strategies, such as swap spread arbitrage, capital structure arbitrage requires a much higher initial capital to attain the same profile of profits and losses. Abstract. %PDF-1.4 %���� H�\Ut�W��9�oD�Q���J7��g(��F�G���r�$H�U�M=V�Q�z�Bk�F����P�LÔ�P�z�X�:ԨZf�����j�~�k�s�9�;���������� �;dk��L����W�x��9cfLw��0�c��n�_>j�B~8r�g�$�]� xref 279 0 obj<>stream Overview. H�b```f``������1�A�X� ��%�w �m���\�iq3r�c������Q����kϱ���� ��� T;߃� 0000001645 00000 n The arbitrage process is retarded by the institutional investor e.g., Life Insurance Corporation of India, Commercial bank. One of the benefits on the Capital Structure • Options, Put-Call Parity, and Valuing the Firm • Summary • Endnotes ... explains the role of arbitrage in valuing capital structure decisions in the context of the Nobel prize-winning Modigliani-Miller theory (M&M). This section does not cite any sources. Section 6 constructs a capital structure arbitrage return index from the individual trades and studies the monthly returns. Section 8 concludes. 0000020463 00000 n 0000020185 00000 n 0000000727 00000 n <]>> 0000016909 00000 n %PDF-1.2 %���� Request PDF | How Profitable Is Capital Structure Arbitrage? • There are no arbitrage opportunities in the economy. 0000000776 00000 n The idea behind capital structure arbitrage is hardly rocket science. 0000020627 00000 n capital structures around the world are also discussed. 0000054009 00000 n Capital Structure Arbitrage Definition Capital structure arbitrage refers to a strategy used by companies where they take advantage of the existing market mispricing across all securities to make profits. The Anatomy of the same capital structure, namely, trade-off, agency signalling! 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