Working Paper Series, Department of Finance, Copenhagen Business School
Claus Bajlum and Peter Tind Larsen
Capital Structure Arbitrage: Model Choice and Volatility Calibration
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.
Keywords: na; (follow links to similar papers)
JEL-Codes: G12; G32; (follow links to similar papers)
43 pages, January 1, 2007
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