Only six months after establishing its hedge fund arm, KBC Alternative Investment Management (KBC AIM) assets under management increased tenfold to US$500 million, on the strength of strong performance in their Convertible Bond Arbitrage Fund. KBC's second offering, the Convertible Opportunities Fund, proved to be even more impressive, posting a 23% return in its first year and being named Best Convertibles and Equity Arbitrage Fund by EuroHedge in 2002.
Building on this success, KBC AIM has now decided to launch a new Credit Arbitrage Fund, applying a novel strategy aimed at exploiting mispricing between the credit default swaps and equity of target firms. Will this new fund provide KBC with another successful offering, or will venturing into unknown waters result in losses this time around?
INSEAD Associate Professor of Finance Lucie Tepla studies two of KBC AIM's funds to illustrate opportunities for profit from trading different classes of a firm's securities against each other, and how lessons learned from one tried and tested strategy (Convertible Arbitrage) can be applied to a new one (Credit Arbitrage).
In the (A) case, KBC convertible bond arbitrage trader Mark Punt looks for 'cheap' volatility, taking a long position in Duke Energy convertible bonds and simultaneously shorting the company's shares to put on a delta-hedge. However, with credit risk exposure still present in the bond position, additional trades are required to fully hedge the position.
Mark knows a number of alternatives commonly used to manage credit risk: using credit default swaps (CDS), by modifying the size of his short position, or buying out-of-the-money puts on the company's stock. However, each alternative changes the properties and risk exposure of the trade, leading Mark to wonder: what combination of positions in Duke Energy is required to create a perfectly hedged arbitrage trade?
In the (B) case, after an announcement that British Airways long-term credit rating has been downgraded to junk status, KBC bond trader Steve Dash notices an inconsistency between the market value of BA credit default swaps and the company's share price. Steve wonders whether the equity markets have overreacted, if the swaps are slow to adjust, or if there are other factors that could support this excessive spread.
This case explains the underlying logic of capital structure arbitrage, reviews recent developments in credit risk modeling and shows how a Merton-type structural model of credit risk can be used to evaluate pricing and credit spreads through examining a company's capital structure.
Using the market information and credit model data provided, can you structure a series of trades to exploit this mispricing and make a tidy profit? Or is it possible that the market data and a close examination of inputs could indicate that Steve's model is mistaken, and BA securities are not mispriced at all?
This multi-fund case study provides an excellent bridge between arbitrage theory and practical trade execution. Fundamentals of convertible arbitrage are reviewed, along with basic strategies for trading volatility and hedging risk, followed by additional considerations, including sophisticated strategies to hedge out different types of risk.
Actual trade opportunities are used to create a real-world context, forcing readers make sense of market data, decide which signals are most relevant and determine the most appropriate hedging strategies for each trade. Additional questions are included to challenge readers and test depth of understanding, drawing attention to factors underlying credit models and using Black Scholes to determine hedge ratios for arbitrage trades.