Rethinking Capital Structure Arbitrage

This white paper tests new strategies for both US and European obligors. It finds that these outperform traditional arbitrage trading during the financial crisis.

The new strategies show higher Sharpe ratios when credit default swap (CDS) and equity-implied spreads are co-integrated. The correlation of the new trading rules with the traditional one is low or negative even during the crisis, which suggests that by combining new and old rules, portfolio managers could reap diversification benefits at times when diversification, and hence risk reduction, is hardly achievable.