The article examines the risk and return of capital structure arbitrage, which
exploits the mispricing between a company’s credit default swap (CDS)
spread and equity price. The analysis uses the CreditGrades benchmark model, a
convergence-type trading strategy, and 135,759 daily CDS spreads on 261 North
American obligors. At the level of individual trades, substantial losses can
occur as a result of the low correlation between the CDS spread and the equity
price. An equally weighted portfolio of all trades, however, produced Sharpe
ratios similar to those for other fixed-income arbitrage strategies and hedge
fund industry benchmarks.