Capital Structure Arbitrage: Using Debt and Matching Duration Put Options to Generate Alpha

Abstract

Capital structure arbitrage has emerged as a popular trading strategy for hedge funds and a popular topic of research in academia over the past two decades. Previous research and publicized trading strategies, however, focus on arbitrage between credit default swaps (CDS) and corporate debt and rely on theoretical models such as the Merton Model (Merton, 1974) and its variants. I hypothesize and backtest a unique strategy that does not rely on short-term price convergence but on the proper judicial implementation of the absolute priority rule in U.S. bankruptcy courts by purchasing close-to-maturity corporate debt and matching duration put options. My model filters for opportunities where positive returns can be generated on both extreme ends of the entire continuum of possibilities (full bankruptcy or full recovery) and thus all possible scenarios that lie in between. My results provide significant risk-adjusted alpha with a success rate of ~99% across all implemented trades, losing money in <1% of trades.