Capital Structure Arbitrage
A company's stock, bonds, and credit default swaps are all claims on the same underlying business, so when the market prices them inconsistently with each other, that inconsistency is tradable.
Prerequisites: Cointegration, Spread Construction and Hedge Ratios
Equity and debt look like completely different assets, but they're both claims on the same company's future cash flows — equity gets what's left after debt is paid, debt gets paid first but has no upside. A rise in how risky the market thinks a company is should show up in both markets: equity should fall or get more volatile, and credit spreads (or CDS) should widen. Capital structure arbitrage trades the moments when those two markets disagree about that risk.
Stock price, credit spreads, and equity volatility are all driven by the same underlying variable — how likely the company is to run into financial trouble. A model linking them lets a trader spot when one market has priced in more (or less) distress than the other, and trade the gap: typically long the "cheap" side of the relationship and short the "rich" side, hedged for the shared company-specific risk.
The link between stock and credit
The intuition, going back to the Merton model, treats equity as a call option on the firm's assets with the debt as the strike: equity holders only get value once asset value clears what's owed to bondholders. That framing implies a direct relationship — as a firm's assets fall in value or become more volatile, equity should fall and get more volatile, and the chance of default (and so the CDS spread, the annual cost of insuring the company's debt) should rise. A capital structure arbitrage desk estimates that implied relationship and checks whether the actual equity price and CDS spread currently agree with it.
Worked example
A company's 5-year CDS spread jumps from 150 to 280 basis points on a sector-wide credit scare, while its stock has only fallen 4% and its options-implied volatility has barely moved — a much smaller reaction than the CDS move alone would suggest is warranted by the model. A capital structure arbitrage desk sells CDS protection (effectively going long the company's credit, collecting 280 bps a year, betting the spread narrows back toward what equity is implying) while buying out-of-the-money puts on the stock as a hedge, in case the credit move turns out to be the correct read and equity is the one that's behind.
What this means in practice
The strategy is a relative-value bet between two markets that price the same underlying risk differently, hedged so that a pure move in the level of company risk (both sides moving together) doesn't hurt much — only a re-convergence, or divergence, between the two matters to the position's P&L.
Equity and credit markets can stay disconnected for a long time, especially when technical factors (index rebalancing, forced selling, liquidity differences) rather than fundamentals are driving one side. The Merton-style link is a model of typical behavior, not a law, and a position can bleed carry waiting for a convergence that takes longer than expected — or never fully arrives.
Related concepts
Practice in interviews
Further reading
- Merton, 'On the Pricing of Corporate Debt: The Risk Structure of Interest Rates', Journal of Finance (1974)