Rethinking Capital Structure Arbitrage: A Price Discovery Perspective

Journal of Alternative Investments, Vol. 22, pp. 75-91, 2020, https://jai.pm-research.com/content/22/4/75

Posted: 2 Jun 2012 Last revised: 24 May 2020

See all articles by Davide E. Avino

Davide E. Avino

University of Liverpool; Financial Mathematics and Computation Cluster

Emese Lazar

University of Reading - ICMA Centre

Date Written: May 23, 2019

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. Here we 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. We implement the strategies for both US and European obligors and find that these outperform traditional arbitrage trading during the financial crisis. Furthermore, the returns of the new strategies have lower correlation with market returns than the standard capital structure arbitrage.

Keywords: credit spreads, price discovery, credit derivatives, information flow, convergence trading, financial crisis, limit of arbitrage

JEL Classification: G01, G11, G12, G14, G20, D8, D53

Suggested Citation

Avino, Davide E. and Lazar, Emese, Rethinking Capital Structure Arbitrage: A Price Discovery Perspective (May 23, 2019). Journal of Alternative Investments, Vol. 22, pp. 75-91, 2020, https://jai.pm-research.com/content/22/4/75, Available at SSRN: https://ssrn.com/abstract=2071920 or http://dx.doi.org/10.2139/ssrn.2071920

Davide E. Avino (Contact Author)

University of Liverpool ( email )

Chatham Street
Brownlow Hill
Liverpool, L69 7ZA
United Kingdom

Financial Mathematics and Computation Cluster

Dublin
Ireland

Emese Lazar

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 (0)1183 786675 (Phone)
+44 (0)1189 314741 (Fax)

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