Tail Risk Killers: How Math, Indeterminacy, and Hubris Distort Markets

CHAPTER 31Emerging Market Sovereign Credit Derivatives and Equity Markets

Boaz Weinstein came up with a terrific strategy called capital structure arbitrage.¹ The idea behind the strategy is that investors in bonds and investors in equities value a firm’s liabilities and future prospects inconsistently. Depending on the view, one can short (buy) the bond and buy (short) the equity. Factors such as momentum for equity and interest-rate sensitivity for investment grade (IG) bonds make the strategy essentially short-long. It is conceivable that both assets could be purchased like a full basis trade.

Credit-default swap (CDS) spreads provide a useful tool to generalize this trade. The idea is to use CDS spreads to time a short equity in the emerging-market ...