What is Capital Structure Arbitrage?

Capital structure arbitrage refers to a strategy used by companies where they take advantage of the existing market mispricing across all securities to make profits. In this strategy, there is buying undervalued securities and selling of the same company's overvalued securities. The main objective is to make use of the pricing inefficiency to make a profit when a company issues its capital structure. There is anticipation that the pricing difference, will at some point cancel out.

How Does Capital Structure Arbitrage Work?

In most cases, opportunities for mispricing exists between debt-linked and equity-linked securities. Mispricing is usually short-term and happens because both the equity and the debt markets have different market structures and participants. The two create different price discovery speeds as well as processes.

Example of Capital Structure Arbitrage

For instance, if a company surprisingly reports disappointing earnings in the stock market, there will be an immediate drop in the companys stock at 10 percent. However, when it comes to the companys bond price, similar information will not be reflected immediately. It takes a few days for the bonds price to go down, mostly at 2 percent. What does this mean for a company? It is possible for a company that takes advantage of the market dynamics and mispricings to make immediate profits.

Volatility vs. Debt Price & Equity Securities

Fund managers have the responsibility of comparing prices and determining value. Where a manager identifies more value compared to the reflected price, it becomes a valuable opportunity to increase the companys profits. In most cases, the managers will look at the difference in valuation between a companys equity and debt securities. However, to be able to understand the two financial liabilities relationship, they have to incorporate what we call volatility. Under Volatility, there is a division of the companys assets value between its equity and debt securities. Where a company has no net debt, the companys equity price will equal its assets' value. However, if the capital structure happens to have net debt, equity will automatically become a call option on the assets of the company. The call options price will then equal that of the debts face value. Similarly, the behavior in prices reflects that of assets value less than the call options value. Here is the formula; Debt + Equity = Assets (Assets - Call) + Call = Assets Generally, volatility is an essential ingredient when it comes to the value of both equity and debt securities a corporation issue. Volatility increases with an increase in option prices. In other words, the equity value increases only if the volatility of returns on company assets increases, holding other things equal. Note that a change in volatility does not change the assets value. So, asset and equity value risk happen to be the same if a company is fully financed with equity.If for example, a bank buys debt obligations, the financing of this debt obligation will be done using a bank capital and bank borrowing. Generally, the amount held against a loan by a bank is what we call equity risk. For every capital a bank uses to finance a loan, it must earn a hurdle rate to come up with a loan that reflects the credit risk. Since there is a high equity risk with loans below investment grade, the level of equity a lender uses to finance the loan must be high.

How to Create Synthetic Credit Risky Debt

To hedge and replicate risks, we can use derivatives contracts. The same applies when hedging credit risks. To replicate credit risky debts performance, most managers would use Credit Default Swaps (CDS). Those who are not able to transact CDS contracts can use a combination of securities in cash listed derivatives markets as an alternative. The combination may include the following:

• US treasury bonds
• Company issued stock
• The company issued stock and listed options

The above are combined reflect the company debt obligations performance. The following relationship is important to be able to achieve this. Debt = Cash + Put or Debt = Asset - Call Note that you cannot buy company assets or options on such assets. However, you can use the Company's equity as a proxy on the equity. Generally, lenders always expect a certain level of recovery in case of a default. For this reason, the recovery act can be a put option because it acts as a floor to the credit risk debts value. Therefore, the replication of a credit risky debt performance can be through:

• Purchasing equity
• Selling a call
• Buying a put

Here is the formula; Debt = Cash + Put or Debt = Asset - Call In theory, the capital structure arbitrage trade is less risky compared to one long security. A number of capital structure arbitrage strategies require leverage for a company to be able to achieve its target. For this reason, a trade which goes against this can be overwhelming.