How Profitable Is Capital Structure Arbitrage?

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.