Equity and CDS - portal.idc.ac.ilportal.idc.ac.il/.../annualsummit/documents/c08-2.pdf · have more integrated equity and credit markets than others. yMost likely reason: Arbitrage

Relative Pricing of Debt and EquityRelative Pricing of Debt and Equity

Th C di M kThe Credit MarketCaesarea Center 5th Annual Conference, IDC, Herzliya

Nikunj Kapadia, University of Massachusettshttp://people.umass.edu/nkapadia

The Fundamental Syllogism The Fundamental Syllogism 1. Debt and equity are claims on the same underlying firm.q y y g

2. Arbitrageurs actively arbitrage equity and credit markets.

3. Ergo, equity and credit markets are highly correlated.g q y g y

Capital Structure Arbitrage

l b k l d hCapital structure arbitrageurs take long and short positions in different instruments of a company’s capital structure.

Debt against stockDebt against stockConvertible bond arbitrage: Long convertible bond, short stockSenior debt vs. junior securities

Newer strategies: Stock and CDS spread

Euromoney December 2002Euromoney, December 2002Can investors and bank prop desks really be so confident of the correlations between debt and equity to make a business out of arbitraging them? A few between debt and equity to make a business out of arbitraging them? A few brave souls think so. This new line of business has sprung from recent fundamental changes in how credit markets trade. “The number one reason why investors are getting involved in capital structure arbitrage now is because of the development of the credit default market,” says Jim Vore, an executive director in credit derivatives at Morgan Stanley in New York. “Even with the right theoretical models and the right views, investors weren’t able to go long equity and short debt. Default swaps changed that. Credit is now much more tradable.”

Source: “And now for capital structure arbitrage,” Euromoney, December 2002.

YetYet….

“Few things in investing are certain but this one is: The Motorola Few things in investing are certain, but this one is: The Motorola bond and share prices can't both be right. If there really is a major risk that the company will end up defaulting on its $4 billion worth of bonds, its equity shouldn't be valued at $20 billion.

Wall Street Journal, 1 April 2008

Why do capital structure arbitrageurs not arbitrage across Why do capital structure arbitrageurs not arbitrage across Motorola's stock and bond?

Stock Price vs 5 Year CDS Spread Stock Price vs. 5-Year CDS Spread

Alcoa

60

70

Alcoa2001-05

40

50

60

20

30Spread5y

0

10

0 5 10 15 20 25 30 35 40 45 500 5 10 15 20 25 30 35 40 45 50

Stock Price vs. 5-Year CDS Spread Hilton Hotel

450

500

2001-05

300

350

400

150

200

250Spread5y

0

50

100

0

0 5 10 15 20 25 30

Stock Price vs 5 Year CDS Spread Stock Price vs. 5-Year CDS Spread

GM

1400

1600

GM2001-05

1000

1200

400

600

800Spread5y

0

200

0 10 20 30 40 50 60 70 800 10 20 30 40 50 60 70 80

Hedge ratiosHedge ratiosThe hedge ratio between the stock and CDS is computed using a g p gmodel like CreditGrades.

The hedge ratio is sensitive to model parameters.

But that is just part of the issue: The bigger problem is that the sign of the hedge may be wrong!

That is both the stock price and CDS spread may increase (decrease) That is, both the stock price and CDS spread may increase (decrease) simultaneously.

Euromoney December 2002Euromoney, December 2002In early November credit protection on building materials group Hanson was trading at 95bp while some traders said the correct Hanson was trading at 95bp.while some traders said the correct valuation was 160bp. Its share held steady. That was the trigger that capital structure arbitrageurs were waiting for.

d h lk d b h ll h One trader who talked to Euromoney bought €10 million-worth of Hansen’s five-year credit default swap over the course of November 5 and 6 when they were at 95bp. At the same

d l f d d ftime, using an equity delta of 12% derived from a proprietary debt equity model, he bought €1.2 million-worth of stock at $2.91 (€4.40). Twelve days later it was all over. On November 18, with Hanson’s default spreads at 140bp and the share price at $2.95, the trader sold both positions. Unusually, both sides of the trade were profitable (emphasis added) y f p f ( p )

How often is the sign correct?How often is the sign correct?

5 business day interval: 53 8% (all) 52 3 (IG) 55 6 (HY) 5 business day interval: 53.8% (all), 52.3 (IG), 55.6 (HY)

10 business day interval: 58.1% (all), 56.0 (IG), 60.7 (HY)

25-business day interval: 63.7% (all), 60.8 (IG), 65.3 (HY)25 business day interval: 63.7% (all), 60.8 (IG), 65.3 (HY)

50-business day interval: 68.5% (all), 66.2 (IG), 71.5 (HY)

All = 200 firms over 2001-05

IG = 95 investment grade firmsg

HY = 105 high yield firms

Sign may be wrong even with large t i d l i g imovements in underlying price

When signs are wrong (CDS spread and stock price both i d 2 th i d)increase or decrease over a 2-month period):

HY: The average stock return in absolute terms is 10% and the average CDS spread change is 52 bpsIG: The average stock return is 7.4% and the average CDS spread change is 15.9 bps.

When signs are correct:HY: The average change in stock return is 18% and CDS spread i 108 bis 108 bps.IG: The average change in stock return is 12%, and CDS spread change is 30 bps.

GM: Stock and CDS over 2001 05GM: Stock and CDS over 2001-05801600

60

70

1200

1400

40

50

800

1000

Spread5y

20

30

400

600

PRC

0

10

0

200

1/2/2001 1/2/2002 1/2/2003 1/2/2004 1/2/2005

Correlations between innovations in CDS d d t k iCDS spreads and stock prices

5 business day interval: -0 125 business day interval: 0.12

10 business day interval: -0.16

25 business day interval: -0.2525 business day interval: 0.25

50 business day interval: -0.33

Notes: Median Kendall correlation across 200 firms, 2001-05

The Role of Arbitrageurs

Which statement is more correct?

1. Debt and equity markets are not highly correlated, so they are not difficult to arbitrage.

2 Debt and equity markets are difficult to 2. Debt and equity markets are difficult to arbitrage, therefore debt and equity markets are not highly correlated.

Limits of ArbitrageLimits of ArbitrageTraditional concept of arbitrage: Risk-less, self-financing, no p g , g,constraints on size of position.

In practice: risky, capital-constrained.

Ri k f h SRisks of the StrategyLiquidityq y

Idiosyncratic risk

Uncertain horizon of convergenceg

LiquidityLiquidityDespite the size of both the CDS and equity markets, liquidity of a fi ’ i di id l i i firm’s individual securities matters.

In 5.7% of all 1-week intervals over 2001-05 across 200 firms, either the stock price change was zero, or the CDS spread change was zero.

Statistical tests: Cross-sectional correlation depends on credit k l dmarket liquidity.

The greater the number of quote providers to Markit, the lower the proportion of zero spread changes, and greater the integration of the p p p g g gequity and credit market.Equity market liquidity has a secondary impact, suggesting that the credit market liquidity is the binding constraint.credit market liquidity is the binding constraint.

Idiosyncratic RiskIdiosyncratic Risk“Fundamental” risk that cannot be hedged.

Includes risk of wealth transfers across parts of the capital structure: Firm might undertake corporate action that results

l h f h l in wealth transfers across the capital structure.Change in dividend policyChange in investment policyChange in investment policyMerger, divestiture

Idiosyncratic Risk: Motorola's equity and debt

“Moto's leadership announced last week that it's spinning off its struggling oto s eade s p a ou ced ast wee t at t s sp g off ts st ugg g mobile phone business, to focus on all its unsexy (read: profitable) divisions, like police radios and cable modems.Still up in the air: How will the company's $4 billion worth of Still up in the air: How will the company s $4 billion worth of outstanding bonds be allocated between the two companies? A spokeswoman confirmed that the company isn't yet ready to say.”

W ll St t J l 1 A il 2008Wall Street Journal, 1 April 2008

It is not surprising that Motorola's stock and credit markets divergediverge.

What about profits?Gi th i t f i k t d t Given the existence of risks, a convergence trade cannot simply be entered into whenever equity and credit markets diverge.g

Requires an evaluation of the profit potential, given the risk.Generation of private, costly information

Informational Sensitivity Informational Sensitivity Informational sensitivity of the stock and bond: How sensitive are the securities to (private) information?

E l k h ld b l h Even a large stock price change would barely impact the price of an almost riskless bond.

Greater the riskiness of the bond, greater the integration of the two markets.

GM’s stock and CDS are more highly correlated than those of Alcoa.

SummarySummaryThe equity and credit markets are not highly correlated.

But there is significant cross-sectional variation – some firms have more integrated equity and credit markets than others.

Most likely reason: Arbitrage is risky, and arbitrageurs are risk-averse.

Integration of the two markets for any specific firm is g y pimpacted by (i) liquidity, (ii) idiosyncratic risk, and (iii) informational sensitivity of the firm’s stock and bond.