Diksia.com - Capital structure arbitrage is a sophisticated investment strategy where traders exploit pricing inefficiencies between different securities issued by the same company, such as bonds and stocks. By carefully analyzing the company’s financial health and market conditions, they aim to profit from the mispricing. Interested in how this could enhance your investment approach? Discover the intricacies and potential rewards as we explore further.
What is Capital Structure Arbitrage?
Capital structure arbitrage refers to trading strategies that take advantage of the relative mispricing across different security classes issued from the same company’s capital structure. Typically, mispricing opportunities arise between equity-linked and debt-linked securities. These temporary mis-pricings arise because debt and equity markets have different participants and market structures that create different price discovery processes and speeds.
For example, if a firm surprises the market and reports disappointing earnings, a company’s stock may immediately fall 10 percent, but that same information may not be reflected in the company’s bond price until several days later and may effect a drop in the bond’s price of only 2 percent. In such a scenario, it may be possible to profit systematically from such mis-pricings and divergent intermarket dynamics.
How Does Capital Structure Arbitrage Work?
The central idea of capital structure arbitrage is to go long undervalued securities linked to one part of the company’s capital structure while hedging by going short overvalued securities linked to another part of the capital structure. This is a relative value trade that utilizes only one company’s securities. It is most similar to a convertible arbitrage strategy where the portfolio manager goes long the convertible bond but short the underlying stock.
One of the most common forms of capital structure arbitrage involves trading the company’s bonds and credit default swaps (CDS). A CDS is a derivative contract that allows the buyer to hedge against the risk of default by the issuer of the bond. The buyer pays a periodic fee to the seller and in return receives a payoff if the issuer defaults on its debt obligations. The CDS price reflects the market’s perception of the issuer’s credit risk.
