Capital structure arbitrage merton model

Abstract This paper examines the risk and return of the so-called ficapital structure arbitrage,fl which exploits the mispricing between a company™s debt and equity. Speciþcally, a structural model connects a company™s equityprice with its credit default swap (CDS) spread.

A capital structure arbitrage describes an arrangement whereby investors exploit mispricing between the yields received on two different loans by the same issuer. For example, assume that the reference entity has both a commercial bank loan and a subordinated bond issue outstanding, but that the former pays Libor plus 330 basis points while the latter pays Libor plus 315 basis points.

Merton model, integration of equity and credit markets will depend on costs and risks associated with convergence trades. In related work, Duarte, Longsta and Yu (2007) and Yu (2006) study the pro tability of capital structure arbitrage, and show, as we do, that the returns are positive, positively underpinnings of the Modigliani-Miller theory itself. If changes in the financial structure of the firm affect the consumption and investment opportunity sets open to economic agents, then the pivotal role played by value maximization in arbitrage arguments may have to be rejected. equity and credit markets. That is the opportunity for arbitrage. 1.1 The problem of Capital Structure «Capital Structure theory refers to a systematic approach to financing business activities through a combination of equities and liabilities. Capital structure competing theories explore the relationship between equity financing, 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.

optimal capital structure, although he did not pursue it. In the context of the above assumptions, and the observations surrounding them, Merton (1974), examined the valuation of corporate debt in three possible manifestations:3 zero-coupon debt, coupon-bearing debt, and callable debt. In each case his paper provided tractable and in- Question: In 1958 Franco Modigliani And Merton Miller (MM) Published A Set Of Research Papers That Revolutionized The Theory Of A Corporation's Capital Structure. In Their First Research Paper, MM Proposed A Set Of Assumptions That, On The Surface, May Seem Unrealistic, But These Assumptions And MM's Algebraic Approach Provided The First Significant Attempt To ... A capital structure arbitrage describes an arrangement whereby investors exploit mispricing between the yields received on two different loans by the same issuer. For example, assume that the reference entity has both a commercial bank loan and a subordinated bond issue outstanding, but that the former pays Libor plus 330 basis points while the latter pays Libor plus 315 basis points. In corporate finance, the Merton model is a foundational building block of the theory of capital structure, the analyses of agency-theoretic relations, conflicts between equity and bond holders, incentives of equity holders to engage risk-shifting activities, and more. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. optimal capital structure, although he did not pursue it. In the context of the above assumptions, and the observations surrounding them, Merton (1974), examined the valuation of corporate debt in three possible manifestations:3 zero-coupon debt, coupon-bearing debt, and callable debt. In each case his paper provided tractable and in-