Capital Structure Arbitrage: An Analysis of the Australian CDS Market
44 Pages Posted: 15 Dec 2010 Last revised: 13 Feb 2011
Date Written: December 14, 2010
This study investigates the ability of the CreditGrades model to estimate Credit Default Swap (CDS) spreads by comparing the difference between model and market spreads using a number of volatility inputs. We then develop a convergence style capital structure arbitrage trading strategy and test its profitability in the Australian CDS market before and during the financial crisis. We conclude that model performance before the crisis is consistent with previous literature, yet model and market spreads diverge considerably throughout the more volatile period. Although forward-looking option-implied volatility inputs produce inferior fit compared to long-term historical volatility inputs, they are more correlated with medium term changes in market spreads, and thus significantly more profitable within the trading strategy during the volatile period. While trades using all volatility inputs are highly risky at both the individual obligator and the iTraxx Australia Index level, those based on implied volatility are found to be highly profitable, on average, after transaction costs are taken into account. The strategy is significantly less risky when positions are combined into an equally weighted index of arbitrage trades. Financial firms, with which structural models have traditionally struggled, are included in the sample by way of a model calibration procedure, and their inclusion does not decrease the accuracy of the model, nor the profitability of the trading strategy.
Keywords: Capital Structure Arbitrage, Credit Default Swaps, Model Evaluation
JEL Classification: C51, C53
Suggested Citation: Suggested Citation