Managing Hedge Fund Risk and Financing: Adapting to a New Era

Capital structure Arbitrage Strategies

Capital structure arbitrage refers to trading strategies that take advantage of the relative mispricing across different security classes issued from the same company's capital structure. Typically, mispricing opportunities arise between equity-linked and debt-linked securities. These temporary mis-pricings arise because debt and equity markets have different participants and market structures that create different price discovery processes and speeds. For example, if a firm surprises the market and reports disappointing earnings, a company's stock may immediately fall 10 percent, but that same information may not be reflected in the company's bond price until several days later and may effect a drop in the bond's price of only 2 percent. In such a scenario, it may be possible to profit systematically from such mis-pricings and divergent intermarket dynamics.

These strategies usually can be implemented by, and require the management of, offsetting positions of an issuer's debt, CDSs, asset swaps, and equity and equity option securities. The central idea is to go long undervalued securities linked to one part of the company's capital structure while hedging by going short overvalued securities linked to another part of the capital structure. This is a relative value trade that utilizes only one company's securities. It is most similar to a convertible arbitrage strategy where the portfolio manager goes long the convertible bond but short the ...