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Capital Arbitrage




An Introduction to




Capital Structure Arbitrage is one of the most exciting areas in contemporary capital markets.  To exploit these opportunities, a good understanding is needed of equity derivative, credit derivatives, and their relationship via a model of corporate structure.  This course provides a practical introduction to a fast growing form of trading.

Topics Covered

  • Fundamental models of corporate structure
  • Trading opportunities resulting from these models
  • Equity derivatives in capital structure arbitrage
  • Credit derivatives
  • Cross market opportunities and pitfalls
  • Detailed examples

Course Outline

             Day 1 Morning: Key Ideas in Capital Structure Arbitrage

       9:00 10:30: Models of corporate structure

o Detailed introduction to the Merton Model

o Assumptions

o Mathematics

o Consequences for Trading

o The KMV version of the Merton Model

       10:30 10:45: Break

            Understanding Equity Derivatives

       10:45 12:30:  Recap on Equity Derivatives and Convertible Bond Structures

o Pricing Single Stock Options

o The Volatility Smile and the Sensitivity of Far OTM Options to it

o Dividend Risk and Stock Borrow

o Basket Options and Correlation

o Convertible Bonds

o Convertible Asset Swaps and CB Options

12:30 14:00: Lunch

             Day 1 Afternoon: Understanding Equity Derivatives (continued)

       14:00 15:30: Market Practicalities: what instruments are available

o Tenors, Sizes, Providers

o Key Market Drivers: Retail Products, Hedging from Corporates, Convertible Arbitrage

o Investment Banks as Motivated Buyers of Volatility

15:30 15:45: Break


            Understanding Credit Derivatives

       15:45 17:00: Recap on Credit Derivatives

o Default Swaps

o Credit Spread Options

o Asset Swaps and Total Return Swaps.  The key role of Funding.

o The Evolution of Credit Derivatives from single reference bond to multiple deliverables.  Documentation Risk.

o Key Legal Issues and the cases of Railtrack, Conseco and JPMorgan/Mahonia

o Tranche Products and the Characteristics of Equity Tranches

             Day 2 Morning: Understanding Credit Derivatives (continued)

       9:00 10:30: Credit Derivatives Markets: the Participants and their Needs

o Investors vs. Protection buyers vs. Flow traders vs. Arbitrage players

o Differing Accounting and Investment horizon: Banks & Insurers

o Drivers of the Market: Different views of Pricing; Regulatory; Accounting

10:30 10:45: Break

       10:45 12:30: Pricing Credit Derivatives

o Default Probability, Recovery.  What is in a Credit Spread? 

o Pricing Default Swaps using Default Probabilities inferred from Credit Spreads:  Methods and Pitfalls.

o Credit spread migration models.  Pricing Credit Spread Options.

o Actuarial Pricing and Ratings Transitions

o Models of Corporate Structure: KMV

o Pricing using KMV Models.

12:30 14:00: Lunch

             Day 2 Afternoon: Cross Market and Capital Structure Arbitrage

       14:00 15:30: Why might the Arbitrage Exist?

o Organisational issues for investment banks.  Drivers for different views of names between equity and debt markets.

o Sourcing long dated Volatility in Equity Derivatives

o Senior vs. sub: key issues in Recovery Risk

       Real World Pitfalls: Understanding them and Avoiding them

o Movements in the Smile

o Accounting issues and Mark To Market

o Factors driving Credit Spread Movements

o Liquidity Risk

o Activities of other market participants and their effects

15:30 15:45: Break

       15:45 17:00: Typical Transactions in Detail

o Equity Derivative vs. Default Swap

o CB option vs. Default Swap

o CDO Equity Tranche vs. Basket Option

o Questions



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Last modified: January 11, 2016