Thursday, April 21, 2011

Capital Structure Arbitrage explained

Capital Structure Arbitrage usually exploits inefficiencies between credit and equity instruments of a business entity or autonomous economy. Like all arbitrage, it isn't truly risk free; when you eliminate risks from market movement, "little" issues like credit, systemic risks become much more apparent.


1) Convertible Arbitrage: Long convertiable bond/Short the stock
This works when you have a Positive Carry = Bond Yield - (Borrow Rate + Dividend)

2) Capital Structure Arb. with credit instrument ETFs: exploiting the aggregate relationship between credit and equity markets

... we have created using three ETFs – IEF (a Treasury bond ETF), LQD (a corporate bond ETF), and SPY (the S&P500 equity ETF). Critically the need to use a Treasury and corporate bond ETF is due to the need to separate credit risk premia from yield – both ETFs reflect yields and we use IEF to hedge away the risk-free movements in LQD. Based on years of analysis and our proprietary credit cycle view, we find that following a Z-Score of the differential between a carefully weighted combination of these three ETFs enables profitable (though infrequent) signals to be generated.

So there're quite a number of things to explore!

0 Reflections: