A capital structure arbitrageur can exploit the mispricing between the bond and the CDS by taking a long position in the bond and a short position in the CDS, or vice versa, depending on which one is cheaper relative to the other. The arbitrageur expects the bond and the CDS prices to converge over time, as the market corrects the mispricing. The arbitrageur can then close the positions and lock in a profit.
What are the Benefits and Risks of Capital Structure Arbitrage?
Capital structure arbitrage can offer several benefits to investors who are looking for alternative sources of returns and diversification. Some of the benefits are:
- Capital structure arbitrage can generate positive returns regardless of the direction of the market, as it is based on relative value rather than absolute value.
- Capital structure arbitrage can reduce the exposure to systematic risk, as it is largely driven by idiosyncratic factors affecting the specific company’s securities.
- Capital structure arbitrage can exploit the inefficiencies and frictions in the debt and equity markets, such as different liquidity, information flow, and investor behavior.
However, capital structure arbitrage also involves significant risks and challenges that need to be carefully managed. Some of the risks are:
- Capital structure arbitrage requires a high level of skill and expertise in analyzing the company’s financial situation, capital structure, and market conditions, as well as in executing the trades and managing the positions.
- Capital structure arbitrage is subject to model risk, as the arbitrageur relies on a mathematical model to estimate the fair value of the securities and the optimal hedge ratio. The model may be inaccurate, incomplete, or outdated, leading to erroneous results and losses.
- Capital structure arbitrage is exposed to market risk, as the prices of the securities may not converge as expected, or may diverge further, due to unforeseen events or changes in market sentiment. The arbitrageur may face margin calls, liquidity constraints, or forced liquidation, resulting in losses.
Conclusion
Capital structure arbitrage is a sophisticated investment strategy that seeks to profit from the relative mispricing of different security classes issued from the same company’s capital structure, such as bonds and stocks. It involves going long the undervalued security and short the overvalued security, expecting the prices to converge over time. Capital structure arbitrage can offer attractive returns and diversification benefits, but it also entails significant risks and challenges that require a high level of skill and expertise. Capital structure arbitrage is not a strategy for the faint-hearted, but for the savvy and sophisticated investors who are willing to take calculated risks and seize opportunities.
