Ebook Risk in Capital Structure Arbitrage
Capital structure arbitrage is a trading strategy that attempts to exploit mispricing between a company’s liabilities, most commonly between equity and straight or convertible debt. In recent years such strategies have become increasingly popular, particularly among hedge funds, possibly as a result of the development of the credit default swap market that has allowed market participants to take short positions in a credit risk more easily (Currie and Morris (2002)).
While the mechanics of capital structure arbitrage are now widely understood, there is little formal evidence on its risk. Structural models provide one framework for analyzing the risk but, in the classical models of Merton (1974), Leland (1994), Leland and Toft (1996) and others, a correctly constructed triangular hedge between a company’s debt, its equity, and riskless debt should be risk free. On the other hand, recent events in the credit markets suggest that there are times when capital structure arbitrage may be very risky. For example, when S&P downgraded Ford and GM in early 2005, Kirk Kerkorian chose that moment to announce a tender offer for around 5% of GM’s stock, resulting in the prices of GM’s debt and equity going opposite directions and creating substantial losses for capital structure arbitrageurs.
The academic literature on capital structure arbitrage is limited. Yu (2005) analyzes convergence trades involving credit default swaps (CDS) and equity. He finds these “quite risky” and, in particular, prone to large losses when CDS spreads rise quickly. In an analysis of a number of fixed-income arbitrage strategies, Duarte, Longstaff, and Yu (2005) analyze CDS-based capital structure arbitrage and find that these produce promising Sharpe ratios of approximately 0.8. Agarwal and Naik (2000) analyze the performance of hedge funds following a variety of strategies including capital structure arbitrage. Schaefer and Strebulaev (2005) investigate hedge ratios of corporate debt against equity and find that, at the level of individual bonds, the quality of the hedge is quite poor, particularly for bonds with higher levels of credit risk.
Unlike Yu (2005) and Duarte et. al. (2005), the focus of this paper is not the profitability of capital structure arbitrage but its risk and, specifically, its risk at a portfolio level. While Schaefer and Strebulaev (2005) and others have found that the returns on an individual corporate bond are not well explained by the issuing firm’s equity and riskless debt, it remains an open question as to whether a significant fraction of the remaining risk is diversifiable. Encouragingly, in his analysis of CDS, Yu (2005) finds that “. . . when the individual trades are aggregated into monthly capital structure arbitrage portfolio returns, the strategy appears to offer attractive Sharpe ratios ...”. (Yu (2005), p. 32).
The focus of this study is, then, the risk of capital structure arbitrage, and the effectiveness of alternative strategies for managing this risk. In this context, it is important to point out that our calculations are carried on portfolios that are chosen in a mechanical, i.e., passive manner while, in practice, capital structure arbitrageurs choose positions because they judge the debt and equity to be relatively mispriced. It is possible that these latter positions may be systematically more or less risky than the passive positions we study precisely because of the presence of mispricing but we lack the data on actual capital structure arbitrage positions that would be required to decide this question.
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