Capital Structure Arbitrage

[Liming]

Dear David,

I have following areas within the topic of Capital Structure Arbitrage that I need clarification on. Appreciate your kind help on it.

1) Can I sum up the various forms of Capital Structure Arbitrage strategy into a few words like "Spread Arbitrage" and "Relative Value Arbitrage"? (where the spread refers to price differences between two connected securities of the same issuer, which are distorted but are expected to decrease over time)

2) Can I say that examples of Capital Structure Arbitrage strategy include:
normal bond Vs callable bond ; and likewise normal bond Vs putable bond: where the spread is the premium of the option on the firm's bond and the strategy is trying to exploit this premium. For example, for callable bond: normal bond - callable bond = option cost and when traders believe that the option cost is relatively high in the market and will eventually go down, he/she will decide to short normal bond and long callable bond. Take putable bond for example, putable bond - normal bond = option cost and when traders believe that the option cost is relatively high in the market and will eventually go down, he/she will decide to short putable bond and long normal bond.
normal bond Vs convertible bond; and likewise normal bond Vs reverse convertible bond; where the spread is the premium of the option on the firm's share and the strategy is trying to exploit this premium.

3) If 1) and 2) holds true, why can the following strategy be considered a capital structure arbitrage as well? (Actually I don't understand from Question 46: Capital Structure Arbitrage from http://forum.bionicturtle.com/viewthread/1428/ [/siz.e])
a). Long position in the bonds issued by the company, and short position in the company’s stock.
b). Short position in the bonds issued by the company, and long position in the company’s stock.
I don't understand a) and b) because when I follow the Merton approach by replicating these positions with options on firm asset, I can see that a)long bond+short stock = short put + short call on firm asset, making the overall strategy payoff resembling a upside-down 'V'; and b)short bond+long stock = long put + long call on firm asset, making the overall strategy payoff resembling a 'V'. Therefore, not only I can't see a spread between bond and stock but also in this strategy, I see an option straddle-like payoff that depends on the underlying value directional movement (is my analysis correct?)

4) I don't understand how one can arbitrage from volatility surface differences from the following strategy: A long position in a credit default swap on the company and writing put options on the company’s stock capitalizes on the differences in the volatility surface between bonds and equity.

Sorry for bothering you again with so many questions. :-P Thank you very much for your enlightenment!

Cheers!
Liming
7/10/2009

 

[David Harper CFA FRM]

Hi Liming,

Can I first say that I think the definitions employed are somewhat subjective ... I am not aware if "capital structure arbitrage" requires the strict definition given by (the FRM assigned) Jaeger; my sense is that, in practice, is a little fuzzier. With that caveat, yes, I do think your "relative value" captures one-half of the definition. Specifically, my interpretation of capital structure arbitrage (according to Jaeger) *really* has two criteria:

1. a non-directional trade,
2. on two components simultaneously of company's capital structure; i.e., right-hand side of balance sheet. Debt, Equity, and hybrid sources of funding.

so, for example, the "non directional" criteria *excludes* this trade: short position in the preferred stock issued by the company and writing call options on the company’s stock...
...because it is a directional bet

if that is an acceptable interpretation, then:
Re: your "normal bond vs callable bond" trades. Because you have (e.g.) long bond and short putable, you have a non-directional bet and both are capital components, YES, I AGREE this qualifies
Re: normal vs. convertible: YES, I AGREE that qualifies if it is non-directional; e.g., long normal + long convertible is directional

In regard to your analysis of ...
a). Long position in the bonds issued by the company, and short position in the company’s stock.
b). Short position in the bonds issued by the company, and long position in the company’s stock.

...I think that is very smart and I totally agree:
... long-bond + short stock under the Merton framework = (F - put on firm firm assets) + short call on firm assets = short put + short call = top straddle!
... and short bond + long stock = -(F - put) + long call = long put + F + long call = long put + long call = straddle!
...very clever...i have not seen that. Kudos!
Very instructive, I hope others will follow your analysis

I see your point, those are volatility strategies ... are they directional? I'm not sure ... I cannot refute your excellent analysis, nor can i reconcile with Jaeger's strict definition. I think you have gone a bit deeper...maybe I miss someting along with you b/c i can only agree with you analysis

Re: A long position in a credit default swap on the company and writing put options on the company’s stock
Right, that is GARP's phrasing. Here is Jaegers:
long CDS + short equity put is "the manager would buy low volatilty in the credit market and sell high volatility in the equity market"
...so, again, I think your instincts are correct, I don't see the need to invoke a shared volatiltiy surface, i think its simpler

David