Next Article in Journal
Determination of the Optimal Retention Level Based on Different Measures
Next Article in Special Issue
OTC Derivatives and Global Economic Activity: An Empirical Analysis
Previous Article in Journal
Acknowledgement to Reviewers of the Journal of Risk and Financial Management in 2016
Previous Article in Special Issue
Humanizing Finance by Hedging Property Values
Open AccessArticle

Capital Structure Arbitrage under a Risk-Neutral Calibration

Calypso Technology Inc., San Francisco, CA 94105, USA
Academic Editor: Donald Lien
J. Risk Financial Manag. 2017, 10(1), 3; https://doi.org/10.3390/jrfm10010003
Received: 18 October 2016 / Revised: 7 January 2017 / Accepted: 10 January 2017 / Published: 19 January 2017
(This article belongs to the Special Issue Financial Derivatives and Hedging)
By reinterpreting the calibration of structural models, a reassessment of the importance of the input variables is undertaken. The analysis shows that volatility is the key parameter to any calibration exercise, by several orders of magnitude. To maximize the sensitivity to volatility, a simple formulation of Merton’s model is proposed that employs deep out-of-the-money option implied volatilities. 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. The approach seeks to hedge the volatility risk, or vega, as opposed to the exposure from the underlying equity itself, or delta. The results question the efficacy of the common arbitrage strategy of only executing the delta hedge. View Full-Text
Keywords: Merton model; structural model; Credit Default Swap; capital structure arbitrage; algorithmic trading Merton model; structural model; Credit Default Swap; capital structure arbitrage; algorithmic trading
Show Figures

Figure 1

MDPI and ACS Style

Zeitsch, P.J. Capital Structure Arbitrage under a Risk-Neutral Calibration. J. Risk Financial Manag. 2017, 10, 3.

Show more citation formats Show less citations formats
Note that from the first issue of 2016, MDPI journals use article numbers instead of page numbers. See further details here.

Article Access Map by Country/Region

1
Back to TopTop