Limited Arbitrage Between Equity and Credit Markets

Kapadia, Nikunj; Pu, Xiaoling

doi:10.2139/ssrn.1573201

Cited by 14 publications

(20 citation statements)

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“…Therefore, financial distress conditions may result in a decrease in the value of firms' stocks and increase the CDS spread. The empirical works by Collin-Dufresne et al (2001), Blanco et al (2005) and Kapadia and Pu (2012) suggest a weak correlation between stock returns and changes in credit spreads. However, the capital structure arbitrage that exploits the relationships between the CDS and stock prices may enhance the integration and information flows between these markets (Fung et al, 2008).…”

Section: Related Literaturementioning

confidence: 99%

Directional and bidirectional causality between U.S. industry credit and stock markets and their determinants

Shahzad

Nor

Hammoudeh

et al. 2017

International Review of Economics & Finance

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We examine the causal links between U.S. industry-wise credits and stock markets. The full sample bootstrap Granger causality results show that all stock markets Granger cause their CDS counterparts and there is also bidirectional causality for the banking, healthcare and material industries. The short-run parametric stability tests highlight that the full sample parameters are not stable and hence less reliable. The bootstrap rolling window estimations confirm the inconsistency in the CDS-stock causality relationships where bidirectional causalities are also found between the credit and stock markets that vary over different sub-samples. Finally, we analyze the impact of different financial and macroeconomic determinants on the CDS-stock causality through a probit model. Overall, the business conditions, stock market volatility, default premiums, Treasury bond rate and the slope of the yield curve are major drivers of the CDS-stock nexus. Our findings provide possible explanation for varying and mixed previous empirical findings in the existing literature, and hence have useful investment implications.JEL Classification: C32, G20, G32

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Section: Related Literaturementioning

confidence: 99%

Directional and bidirectional causality between U.S. industry credit and stock markets and their determinants

Shahzad

Nor

Hammoudeh

et al. 2017

International Review of Economics & Finance

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show abstract

“…Large CDS moves only occur when the market capitalization drops below EUR15 BN. The difficulty of capturing stock moves against the CDS has also been reported in [31,32]. In effect, the realized movements in the market are reflecting the relative magnitudes of the delta and vega from Table 2.…”

Section: Capital Structure Arbitragementioning

confidence: 67%

Capital Structure Arbitrage under a Risk-Neutral Calibration

Zeitsch¹

2017

JRFM

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By reinterpreting the calibration of structural models, a reassessment of the importance of the input variables is undertaken. The analysis shows that volatility is the key parameter to any calibration exercise, by several orders of magnitude. To maximize the sensitivity to volatility, a simple formulation of Merton's model is proposed that employs deep out-of-the-money option implied volatilities. The methodology also eliminates the use of historic data to specify the default barrier, thereby leading to a full risk-neutral calibration. Subsequently, a new technique for identifying and hedging capital structure arbitrage opportunities is illustrated. The approach seeks to hedge the volatility risk, or vega, as opposed to the exposure from the underlying equity itself, or delta. The results question the efficacy of the common arbitrage strategy of only executing the delta hedge.

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“…Large CDS moves only occur when the market capitalization drops below EUR 15 BN. The difficulty of capturing stock moves against the CDS has also been reported in [20][21]. In effect, the realized movements in the market are reflecting the relative magnitudes of the delta and vega from Table 2.…”

Section: Capital Structure Arbitragementioning

confidence: 67%

“…Equations (20) and (21) are then derived empirically by regressing the CDS against each variable. There are two calculations each for equations (20) and (21). One is calculated on a 90-day rolling window.…”

Section: Anadarko Petroleummentioning

confidence: 99%

Capital Structure Arbitrage under a Risk Neutral Calibration

Zeitsch¹

2016

Preprint

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By reinterpreting the calibration of structural models, a reassessment of the importance of the input variables is undertaken. The analysis shows that volatility is the key parameter to any calibration exercise by several orders of magnitude. In order to maximize the sensitivity to volatility, a simple formulation of Merton's model is proposed that employs deep out-of-the-money option implied volatilities. The methodology also eliminates the use of historic data to specify the default barrier thereby leading to a full risk neutral calibration. Subsequently, a new technique for identifying and hedging capital structure arbitrage opportunities is illustrated. The approach seeks to hedge the volatility risk, or vega, as opposed to the exposure from the underlying equity itself, or delta. The results question the efficacy of the common arbitrage strategy of only executing the delta hedge.

show abstract

Limited Arbitrage Between Equity and Credit Markets

Cited by 14 publications

References 0 publications

Directional and bidirectional causality between U.S. industry credit and stock markets and their determinants

Directional and bidirectional causality between U.S. industry credit and stock markets and their determinants

Capital Structure Arbitrage under a Risk-Neutral Calibration

Capital Structure Arbitrage under a Risk Neutral Calibration

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