Capital Structure Arbitrage: Model choice and volatility calibration

by Claus Bajlum of Danmarks Nationalbank & Copenhagen Business School, and
Peter Tind Larsen of the University of Aarhus

May 29, 2007

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. Although the strategy may seem attractive at an aggregate level, positions on individual obligors can be very risky.

JEL Classification: G11, G13, G33.

Keywords: Credit default swaps, relative value trading, structural models.

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