Capital structure arbitrage capital structure arbitrage outline. The multiple strategies of hedge funds investopedia. Search for related euromoney publications and events markets have crushed banks this year but now some see a profit to be made in arbitraging debt against equity. Managers look for a relative value between the senior and junior securities of the. This paper examines the risk and return of the socalled capital structure. Risk arbitrage, also known as merger arbitrage, is an investment strategy that speculates on the successful completion of mergers and acquisitions. You go long the stock, and then you hedge with singlename credit protection the only way you can effectively go short the debt. This case considers the question of why kkr chose this structure to execute the transaction. The capitalassetpricing model and arbitrage pricing theory.
View test prep capital structure arbitrage 3 from finance 411 at university of michigan. As the exponential growth in the credit default swap cds market has made credit much more tradable and traditional hedge fund strategies have. Fan yu the article examines the risk and return of capital structure arbitrage, which exploits the mispricing between a companys credit default swap cds spread and equity price. Its objective is to profit from the pricing inefficiency in the issuing firms capital. And now for capital structure arbitrage university of arizona. Which sets up an easy and obvious capitalstructure arbitrage. Regulatory capital arbitrage complicates the problem of designing a new regulatory structure for the financial sector. We can rewrite the capital structure problem using the asset pricing framework. This distinction yields a valuation formula involving only the essential risk embodied in an assets return, where the overall risk can be decomposed into a systematic and an unsystematic part, as in the arbitrage pricing theory.
Ross departments of economics and finance, university of pennsylvania, the wharton school, philadelphia, pennsylvania 19174 received march 19, 1973. If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. As the exponential growth in the credit default swap cds market has made credit much. Companies often buy or merge with other companies using shares which is sometimes less intuitive than when they use cash. Capital structure arbitrage has lately become popular among hedge funds and bank. Apr 14, 2019 merger arbitrage, also known as risk arbitrage, is a subset of eventdriven investing or trading, which involves exploiting market inefficiencies before or after a merger or acquisition. Capital structure theories capital structure cost of capital. The capital asset pricing model capm is a model that describes the relationship between systematic risk and. Research and development of risk arbitrage trading systems. Capital structure arbitrage, similar to eventdriven trades, also underlies most hedge fund credit strategies. Capital structure theories free download as powerpoint presentation. Both of them are based on the efficient market hypothesis, and are part of the modern portfolio theory. Are there any optimal capital structure of firms in stock exchange thailand and to examine for the relationship between capital structure and company value. Pdf capital structure arbitrage with a nongaussian.
Investment strategy in which an undervalued security is bought and the same firms overvalued security is sold. A trader believes that debt of a company is under priced trader purchases the cheap corporate bonds hedges his position by purchasing puts on the stocks no default receives yield on bond in excess of what he paid for put option default. Capital structure arbitrage refers to the practice of exploiting relative pricing inefficiencies in the market by taking long and short positions across different instruments and asset classes of the capital structure of the same firm. Request pdf how profitable is capital structure arbitrage. Convertible arbitrage involves the purchase of convertible bonds while shorting the underlying equity as a.
During may and june, capital structure arbitrage was one of the few hedge fund. An investor that employs this strategy is known as an arbitrageur. Capital structure arbitrage and hedging involves taking long and short positions in di. Aug 01, 2012 which sets up an easy and obvious capitalstructure arbitrage. Capital structure arbitrage 3 how efficient are credit. This website uses cookies to distinguish you from other users.
As i was trying to research a little bit how to value a pipeline of drugs still in development actelion spinoff, i stumbled across the socalled contingent value rights cvrs which are often used in pharma takeovers. This strategy seeks securities within a companys capital structure that are mispriced relative to similar or more junior securities. Ja eez alexei tchistyix november 18, 2012 abstract this paper provides a formal model of contingent convertible bonds ccbs, a new instrument o er. First, we merge the cds data with quarterly balance sheet data from compu. Mar 28, 2020 capital structure arbitrage is an investment strategy that seeks to take advantage of disparities between different equities and debt products issued by the same company. The analysis uses the creditgrades benchmark model, a convergencetype trading strategy, and 5,759 daily cds.
Introduction to merger arbitrage merger arbitrage is a process akin to picking up a few pennies and nickels along the way while panning the river for the big prize, gold. You are basically trying to pick up a few shortterm and hopefully low risk dollars in your journey to your longterm investment goals. There is convertible arbitrage, fixed income arbitrage, capital structure arbitrage, and risk arbitrage. There is a significant relationship between capital structure and their total market value in the stock exchange thailand. Contingent convertible bonds and capital structure decisions boris albul dwight m. Arbitrage can also be used to buy and sell two stocks, two commodities and many other securities. Ja eez alexei tchistyix may 28, 2010 abstract this paper provides a formal model of contingent convertible bonds ccbs, a new instrument o ering potential value as a component of corporate capital structures for. The stock market is deep and liquid enough that you can buy your shares without moving the market. These models evaluate the credit risk of corporate debt, and value the equity price as a call option on the asset value of the company i. Risk arbitrage is a type of eventdriven investing in that it attempts to exploit pricing inefficiencies caused by a corporate event.
The initial capital required to produce a 10 % annualized standard deviation of returns is between 45 % and 90 %, whereas other fixed income arbitrage strategies require only 30 % to 65 % of initial capital. The profitability of capital structure arbitrage has been discussed in previous studies. Simple merger arbitrage with share acquisition youtube. This helps us to provide you with a good user experience and also allows us to improve our website. Euromoney december 2002 antony currie and jennifer morris go to our specialist pages on markets and products and regions. Regulatory capital arbitrage opportunities under the.
Profit of their trading strategy was very modest, far less pronounced than. An empirical study of capital structure arbitrage based on. Think of this system of corporate shells as the acquisition vehicle, the organization that is doing the deal. Within the realm of finance, there are many types of arbitrage. Capital structure arbitrage northwestern university. Its objective is to profit from the pricing inefficiency in the issuing firms capital structure with the expectation that the pricing disparity between the. First, i merge the cds data with information on the equity price from crsp. Pdf mergers, acquisitions and financial performance. Contingent convertible bonds and capital structure decisions. The arbitrage theory of capital asset pricing sciencedirect. Merger arbitrage is a type of eventdriven investing, which is an investing strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spinoff. Master thesis capital structure arbitrage strategies. Ja eey alexei tchistyiz april 25, 2010 abstract this paper provides a formal model of contingent convertible bonds ccbs, a new instrument o ering potential value as a component of corporate capital structures for.
Capital structure of the selected firms was found to. Evaluation of conducting capital structure arbitrage. Trading default protection versus equity is going to become the hottest strategy in the. First of all, it implies that capital requirements must apply in some form to the shadow banking system as well as the traditional banking system. What moves the correlation between equity and cds markets. Investors using the strategy will spot such a disparity and then buy or sell assets based on the logical assumption that the market will correct the disparity. Capital asset pricing model and arbitrage pricing theory. Risk arbitrage we aggressively leverage intelligence, research and data to bring strategic decisions to ambiguous opportunities. Risk in capital structure arbitrage london business school. We merge the cds data with the equity price, shares outstanding, and the. Liquidity, limits to arbitrage intro merger arbitrage. Abstract this paper examines the risk and return of the socalled.
Since such trading strategies exploit mispricing between a firms equity and. It is a oneperiod model in which every investor believes that the stochastic properties of returns of capital assets are consistent with a factor structure. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Implementation of the capital structure arbitrage theory in. Capital structure arbitrage revisited index of tinbergen institute.
Weinstein, arbitrage in securities convertible arbitrage. However, correlations increase significantly in bear markets. The capital asset pricing model capm and the arbitrage pricing theory apt have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. We study risk and return properties of capital structure arbitrage strategies aiming to profit from temporal mispricing between equity and credit default swaps. Regulatory capital arbitrage operations regulatory capital arbitrage occurs when there is a difference between regulatory capital and the economic capital estimated by the bank for. Merger arbitrage has a similar riskreward profile to fixed income, but utilizes a different component of the capital structure. Merger arbitrage returns are largely uncorrelated with the market in neutral and bull markets. Typically, equity holders are more optimistic than debt holders. This paper examines the risk and return of the socalled capital structure arbitrage, which exploits the mispricing between a companys credit default swap cds spread and equity price. Capital structure arbitrage value and opportunity page 2. Capital structure arbitrage refers to trading strategies that take advantage of the relative mispricing across di.
The optimal structure would be to have virtually no equity at all, i. Merger arbitrage, also known as risk arbitrage, is a subset of eventdriven investing or trading, which involves exploiting market inefficiencies before or after a merger or acquisition. Regulatory capital arbitrage operations regulatory capital arbitrage occurs when there is a difference between regulatory capital and the economic capital estimated by the bank for a given investment. Ja eey alexei tchistyiz april 25, 2010 abstract this paper provides a formal model of contingent convertible bonds ccbs, a new instrument o ering potential value as a component of corporate capital structures for all types of. This creates opportunities to short overvalued equities against undervalued debt. Journal of economic theory, 3460 1976 the arbitrage theory of capital asset pricing stephen a. Capital structure arbitrage is an investment strategy that seeks to take advantage of disparities between different equities and debt products issued by the same company. Capital structure arbitrage refers to trading strategies that take advantage of the. Its objective is to profit from the pricing inefficiency in the issuing firms capital structure with the expectation that the pricing disparity between the two securities will cancel out converge. The arbitrage pricing theory apt was developed primarily by ross 1976a, 1976b. Posts about capital structure arbitrage written by memyselfandi007. Capital structure arbitrage department of industrial engineering. An organizations capital structure consists of longterm common stock, preferred stock and retains earning. Capital structure arbitrage the capital structure of a company consists of its assets which are the sum of its debt and equity.
Contingent convertible bonds and capital structure decisions boris albuly dwight m. May 12, 2011 finance and capital markets on khan academy. Capital structure arbitrage opportunity sears otcmkts. Pdf the aim of the study is to examine the impact of mergers and acquisition on financial performance in the nigerian financial system. Yu, fan, how profitable is capital structure arbitrage. At the turn of the century, capital structure arbitrage was thought of as one of the most promising and popular arbitrage strategies within the fixed income market. The arbitrage model was proposed as an alternative to the mean variance capital asset pricing model, introduced by sharpe, lintner, and treynor, that has become the major analytic tool for explaining phenomena observed in capital markets for risky assets. It has historically benefitted from rising interest rates, allowing it to provide a natural hedge during periods when fixed income typically declines. The sears holdings corporation shld is an american holding company headquartered in hoffman estates, illinois. Researchers are still not agreed regarding the factors, which influence organizations capital structure, although plenty of research has been carried out which focus on primary determinants of capital structure.
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