Capital Structure Arbitrage

Introduction
Structural Models
CreditGrades
Calibration
Capital Structure Arbitrage
Critiques and Extension
Ouverture
Quantitative Portfolio Management Part 1 :
Pierre GARREAU
Florida State University
17 septembre 2009
P. Garreau Capital Structure Arbitrage
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Press Review
Punch Line
Mise en Bouche
Denitions
Press Review
Volkswagen, Europes biggest carmarker, and Gas natural,
Spains largest natural gaz provider, are among companies for
which the increase in Credit Protection costs has been
disproportionate relative to the move in their equity prices and
stock volatility. ABN Amro Holding NV, 14 Fvrier, 2008
Credit Default Swaps for Wolfsburg have increased 155%
this year. The stock is down 4% in 2008 and the implied
volatility has decreased to 26% from 32% at the start of the
year. Bloomberg, 22 Fvrier, 2008
Telecom Italias stock price and Credit Default Swap seem
to be increasingly correlated, suggesting arbitrage opportunities.
Exane BNP Paribas - Equity Research, 31 Mars, 2008
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Press Review
Punch Line
Mise en Bouche
Denitions
Fig.: 5Y CDS spread on Volkswagen SNR (light blue) - Equity (light purple) - 6
months put implied volality (dark blue)
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Press Review
Punch Line
Mise en Bouche
Denitions
Capital Structure Arbitrage : Strategy that exploits the discrepancies of
prices between derivative products based on the same Capital Structure
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Press Review
Punch Line
Mise en Bouche
Denitions
Mise en Bouche
Price Dierence - Reproduce the behavior of CDS Spread based on
information available in the Equity Market
Capital Structure - Clarify the Theory of Structurarl Models
Strategy - Implement a trading algorithm based on Capital Structure
Arbitrage relying on Equity/CDS positions
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Press Review
Punch Line
Mise en Bouche
Denitions
Credit Risk
The value of the contract at par is so that the two legs equate each other
m(t, T) = (1 R)
1
_
T
t
e
r(Tt)
dP(u)
_
T
t
e
r(Tu)
P(u) du
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Passage Time and Moving Barrier
Firms Valuation (Modigliani-Miller)
Assets Liabilities
Value of the Firm V
t
Equity S
t
Debt B
t
The value of the Firm at Maturity is
Debt B
T
, prorated if V
T
< B
Debt B + Equity S
T
if V
T
B
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Valuation Model and Option Pricing
V
t
= S
t
+ B
t
S
t
= E
Q
_
e
r
u
du
(V
T
B)
+
| F
t
_
B
t
= E
Q
_
e
r
u
du
(B (B V
T
)
+
) | F
t
_
0 5 10 15 20
0
2
4
6
8
10
12
Valeur de l entreprise
V
a
l
e
u
r

d
e

l
a

d
e
t
t
e

(
r
o
u
g
e
)

V
a
l
e
u
r

d
e

l

a
c
t
i
o
n

(
b
l
e
u
)
Fig.: = 30%, r = 5%, D = 10
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Default Model : Black-Scholes-Merton - 1973
The value of the rm is an It process under the risk neutral probability
dV
t
V
t
= rdt +
t
dW
t
We can then compute the Default Probability
P(V
T
B | V
t
) = P(W
Tt

2
2
(T t) ln
_
Be
r(Tt)
V
t
_
| V
t
)
=
_
_
ln
_
Be
r(Tt)
V
t
_
+
1
2
2
(T t)
T t
_
_
We may introduce the debt ratio l
t
=
Be
r(Tt)
V
t
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Default Model : Black-Scholes-Merton - 1973
Credit Spread
Spread between the riskless debt and the risky debt of the Company
m(t, T) =
1
T t
log
_
B
t
e
r(Tt)
B
_
=
1
T t
log
_
1
l
t
_
ln (l
t
)
1
2
2
(T t)
T t
_
+
_
ln (1/l
t
)
1
2
2
(T t)
T t
__
l
t
1 lim
tT
m(t, T) = 0.
l
t
1 lim
tT
m(t, T) = .
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Passage Time Models : Black-Cox - 1976
Hitting Time
Dene the Hitting Time as the time t when V
t
falls bellow the Barrier
B
B
= inf{s t | V
s
B}
Weaken the hypothesis of a default occuring only at Maturity
Proper model for passage times.
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Theorem Consider a process X
t
= at + bW
t
, (a, b) R
2
, and dene
x
t
= min
s[0,t]
X
s
then
P(x
t
x) = (
at x
b
t
) e
2ax/b
2
(
at + x
b
t
)
where is the CDF of a normal random variable.
The relationship between
x
and x
t
is then given by
P(x
t
x) = P(
x
t)
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Survival probability
The previous theorem is used :
Assume a pure diusion : dV
t
= V
t
dW
t
Consider a xed barrier B = L D
a =
2
/2 and b =
x = ln d
L
where d
L
=
V
0
LD
T t t
Therefore the Survival probability
P( > T | > t , L) = (
t
2
+
ln d
L
t
) d
L
(
t
2

ln d
L
t
)
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Mertons Framework
Moving barrier
The uncertainty is on the recovery rate L, so the level of the debt is set
to L D. A distribution can then be specied for f
L
(l ) so that
P( > T | > t) =
_
+
P( > T | > t , L)f

L
(l ) dl
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Study of the sensibilities
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Distribution of the Default barrier
Assume a log-normal law for L
L =

Le
Z
2
/2
i.e.

L = E[L] et
2
= Var (ln L), Z N(0, 1). It is a random variable, not
a process.
Recall that the barrier is
B = LD =

LDe
Z
2
/2
The survival condition is then
V
0
e
W
t
2
2
t
>

Le
Z
2
/2
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
The survival condition is then equivalent to
2
2
_
t +

2
2
_
+
_
W
t

Z
_
. .
X
t
ln
_

LD
V
0
e
2
2
_
. .
B
The following quantity is thus of interest
P( > T | > t)
Two possibilities
Approximate

X
t
- Finger (2002)
Exact Formula not the formula published by Credit Grades
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Fingers approximation (2002)
Approximate X
t
by a process of equivalent mean and variance
X
t
=
2
2
_
t +

2
2
_
+
_
W
t

Z
_
t 0
X
t
=
2
2
_
t +

2
2
_
+ W
t+
2
t
2
The uncertainty on the barrier is then encompassed in a time shift.
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
According to this approximation, the following survival probability is
obtained :
P( > T | > t) = (
A
t
2
+
ln(d)
A
t
) d.(
A
t
2

ln(d)
A
t
)
A
t
=
_
2
t +
2
and d =
V
0
e
2
2
LD
But the probability to get a default for t < 0 is positive...
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Exact Survival Probability
Use the conditional probability on the default barrier. The survival
condition is
W
t

2
2
t
. .
ln
_
LD
V
0
_

2
2
+ Z
. .
ln d+Z
Hence the survival probability :
P( > T | > t) =
_

_
ln d z

2
2
t
t
_
de
z
_
ln d + z

2
2
t
t
__
f
Z
(z) dz
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Conclusions
Fingers approximation (2002) leads to non negative probabilities for
t (
2
, 0]
The exact default probability is not the one given by Finger (2002)
The dierence between the 2 approaches is marginal
Use of the approximation for the computation of greeks
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Sensibility to the underlying (t, T) = m(t, T)/S
t
Fig.: Delta CreditGrades for dierent Volatilities - The x-axis displays S/D and
corresponds to the moneyness
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Sensibility to the volatility of the underlying (t, T) = m(t, T)/
t
Fig.: Vega CreditGrades for dierent Volatilities - The x-axis displays S/D and
corresponds to the moneyness
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Barriers dynamic
Check point
+
Input : Market
Asset V
t
Volatility
t
Interest rate r
t
+
Input : Balance
sheet
Debt D
t
Recovery Rate
L
=
Output
Default Proba P( > T | > t)
Spread m(t, T)
Greeks and
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Theory and Arbitrage
Calibration of Inputs
Dene to be the distance to default, in terms of standard deviations
=
1
ln
_
V
t
LD
_
=
1
s
S
V
V
S
ln
_
V
t
LD
_
Consider the 2 extremes
V
t
LD V
t
LD + S
t
V
S

1
s
V
t
S
t

1
s
ln
_
S
t
LD
_
Hence
=
S
t
+ LD
s
. .
1/
t
ln
_
_
_
_
V
t
..
S
t
+ LD
LD
_
_
_
_
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Fig.: Alcatel 5Y CDS Spread : Market (blue) vs 6-months put-implied
CreditGrades (orange) vs Historical volatility CreditGrades (light purple) -
L = 0.5, = 0.3, S
ref
= 8.93
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Volatility
Dene
i
the vector of parameters at time t
i
,
i
= (
L, , r
i
, D
i
, S
i
, S
ref
)
The Quadratic Error
Se(
i
,
i
) =
_
m
mkt
i
m
cg
i
m
mkt
i
_
2
The Average Quadratic Error as an indicator of errors on the entire
period
MSe(, ) =
_
N
i =1
Se(
i
,
i
)
The ratio of Quadratic Errors for comparison
RMSe(,
T
,
T
) =
MSe(,
T
)
MSe(,
T
)
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Comparison of errors on Volatilities
3y 5y 7y 10y
1m 0,797 0,747 0,733 0,697
3m 0,928 0,892 0,877 0,846
6m 0,990 0,958 0,934 0,908
1y 0,988 0,977 0,953 0,936
Tab.: Comparison of Model (CreditGrades) errors by Ratio Mean Squared Errors
- The Table presents the windows / options maturity versus Cds Maturity
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Implied CDS Volatility
The CreditGrades Implied CDS Volatility can be dened as :
i
= arg min
| m
mkt
i
m
cg
i
|
The Average Quadratic Error is (re)dened and the Correlation ration
between Cds-implied-to-option-implied and Cds-implied-to-historical :
Se(
i
, m
mkt
i
) =
_
i

ref
i
i
_
2
=
1
N
N
i =1
(
i
,
implied
i
)
(
i
,
histo
i
)
(1)
Distance to Volatility - RMSe Correlation -

0,93 0,86
Tab.: Comparison of Cds-implied volatility to reference (historical /
option-implied) volatility errors by Ratio Mean Squared Errors and Correlation
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Fig.: Alcatel 5Y CDS Spread Implied Volatility (light blue) vs 6-months
put-implied volatility (dark blue) vs Historical volatility (light purple) -

L = 0.5,
= 0.3, S
ref
= 8.93
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Sensibility Validation
We are looking for a validation of the theorical variations of the CDS
Spread with its underlying and volatility of underlying.
t
(S
t+t
S
t
) +
1
2
t
(S
t+t
S
t
)
2
|m(t +t, T +t; S
t+t
) m(t, T; S
t
)|
t
(
t+t

t
) |m(t +t, T +t;
t+t
) m(t, T;
t
)|
S
t
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Fig.: 5Y CDS Spread variations vs Equity variations-

L = 0.5, = 0.3, T = 5
yrs,
s
= 50% - Delta eect (blue), Gamma eect (red) and both (purple)
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Boundary conditions
Choice of Inputs
Fig.: 5Y CDS Spread variations vs Equity variations -

L = 0.5, = 0.3, T = 5
yrs - Vega eect for S/D = 1 (dark blue) and S/D = 2 (light blue)
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Theoretical framework
Telecom Italia
Entry and Exit Signals
The Arbitrageur plays the convergences of model and market.
The Tracking Error is then naturally introduced
t
= m
mkt
t
m
cg
t
and in particular its mean and variance

t
=
1
t
_
t
0
u
du et
t
=
1
t
_
t
0
(
u

t
)
2
du
Dene the following Entry and Exit Signals
|
t
|
t
+
ent

t
|
t
|
t
+
out

t
It can then be specied : stop-loss, minimal distance to default,
constraint on average length of arbitrage, constraint on correlation
Equity-CDS-Volatility, . . .
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Telecom Italia
Replication Instruments
First instrument : Credit Default Swap.
MtM
t
= (m(t, T) m(0, T))
_
T
t
e
r(Tu)
P(u) du
Objective : Replicate the theoretical CreditGrades spread with a synthetic
portfolio
MtM
th
t
= (
t
t
m
cg
(0, T))
_
T
t
e
r(Tu)
P(u) du
where
t
=
m(t, T)/
s
t
P
t
/
s
t
P
t
+ (
m(t, T)
S
t
m(t, T)/
s
t
P
t
/
s
t
P
t
S
t
)S
t
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Telecom Italia
Setting
Bloomberg : volatility 6-mois imp, S
t
, D
t
L = 0.5 - = 0.3 - S
ref
= 2.03 -
ent
= 0, 25 -
out
= 0, 25
Daily rebalancing, Stop-loss / Prot taking, rebalancing if daily
variations > 15%
Long (s = 1)/short(s = 0) positions taken on both
legs
t
= (1)
s
_
(
t
m
cg
(0, T)) A(t, T) MtM
th
t
Dene a base 100 index of the strategy

I
s
T
= 100
T
i =1
m(0, T)A(t, T) +
i
k=1
k
m(0, T)A(t, T) +
i 1
k=1
k
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Telecom Italia
Fig.: Telecom Italia 5Y CDS Spread (light blue) vs corresponding 5Y
CreditGrades (dark blue) -

L = 0.5, = 0.3, S
ref
= 2.03,
ent
= 0, 25,
out
= 0, 25
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Telecom Italia
Fig.: Telecom Italia 5Y CreditGrades (orange) vs Replication portfolio (dark
blue), weekly weights rebalancing -

L = 0.5, = 0.3, S
ref
= 2.03,
ent
= 0, 25,
out
= 0, 25
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Telecom Italia
Fig.: Alcatel 5Y CDS Spread (light blue) vs corresponding 5Y CreditGrades
(dark blue) -

L = 0.5, = 0.3, S
ref
= 8, 93,
ent
= 0, 5,
out
= 0, 25
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Breaking the Bell Curve
Theoretical Framework
General Motors
The Ludic Fallacy (N. N. Taleb)
The misuse of games to model real-life situations
Asymetry and Heavy Tails
Risk and Uncertainty
Jumps
Fig.: Ericsson Stock Price between September and March 2008
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
General Motors
Double Exponential Jump Process
Incorporate a perturbation in the Gaussian dynamic with an exponential
Levy :
V
t
= V
0
e
L
t
Where
L
t
= t + W
t
+
N
t
i =1
ln Y
i
The jump density is them specied :
f
Y
(y) =
p
+
+
e
y
+
1
y0
+
p
e
y
1
y<0
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
General Motors
Martingale Condition E
Q
[e
iuL
t
] = 1
The Lvy-Khintchine Formula E
Q
[e
iuL
t
] = e
F(iu)t
It-Lvy Formula P(t, V) = E
Q
[g(V
T
) | V
t
= V] with
g(V
t
) = 1
{V
t
>ln d}
Change of Variable P(t, V) F(, y) and Laplace Tansform
U(p, y) = L[F(, y)]
U(p, y) = Ae
y
+ Be
y
+
1
p
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
General Motors
Fig.: GM 5Y CDS on Senior Debt - market (orange) - Double exponential (light
blue) - CreditGrades (dark blue) -
p
= 163.24, q
+
= 0.48,
+
= 0.046,
= 0.11, D = 65,

L = 0.5, = 30%
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Key ideas
Done and To be Done
Bibliography
Wrapping up
Robust Mathematical Framework
Capital Structure
Barrier and Default time
Uncertainty model
Thorough Calibration
Theoretical Validation
Case Studies
Possible Extensions
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Key ideas
Done and To be Done
Bibliography
VBA plugged on Bloomberg screening Stocks 600 daily.
Model Risk ?
Stochastic Volatility, Correlation of underlying, Levy Processes
Gnraliss . . .
All models are wrong, some are useful . . .
Introduction
Structural Models
CreditGrades
Calibration
Ouverture
Key ideas
Done and To be Done
Bibliography
Selected papers
Bajlum, C. and Larsen, P., 2007, Capital Structure Arbitrage :
Model Choice and Volatility Calibration, May.
Dao, B. and Jeanblanc, M., 2006, Double Exponential Jump
Diuion Process : A Structural Model of Endogeneous Default
Barrier with Roll-over Debt Structure, March.
JPMorgan, 2001, Par Credit Default Swap Spread Approximation
from Default Probabilities, Internal document, October.
Tankov, P., 2008, Processus de Lvy en Finance, Cours de
lUniversit Paris-1 Panthon Sorbonne, March.

Capital Structure Arbitrage

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Capital Structure Arbitrage

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Introduction

P( > T | > t , L)f

Dene a base 100 index of the strategy

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