Capital structure arbitrage

: exploiting temporary mispricing between equity prices and CDS spreads using the creditGrades model

Abstract

This study implements a capital structure arbitrage strategy using the CreditGrades model and checks whether this is able to generate excess returns. Using a new methodology to identify mispricing triggers, and taking the EuroStoxx and a European Large Cap Bond Index as our benchmark portfolios, we find that our strategy is able to produce a significant alpha during the period between 2008 and 2015 (2.3% in annualized terms). We find however that our strategy is very dependent on trading opportunities, which tend to occur only when volatility rises above certain levels. In periods of prolonged low volatility, our strategy tends to generate weaker returns. As example, while in the period between 2008 and 2011 we obtain a significant annual alpha of 5.7%, in the period between 2012 and 2015 our alpha is only 0.25% and not statistically different from 0. Therefore, we can conclude our strategy is not able to deliver constant and significant abnormal returns in all periods.

Date of Award	16 Feb 2017
Original language	English
Awarding Institution	Universidade Católica Portuguesa
Supervisor	Nuno Silva (Supervisor)