Abstract
This study utilizes a multi-period structural model developed by Chen and Yeh (Pricing credit default swaps with the extended Geske–Johnson Model. Working paper, 2006), which extends the Geske and Johnson (J Financ Quant Anal 19:231–232, 1984) compound option model to evaluate the performance of capital structure arbitrage. In the paper, first of all, we predict the default probability for each firm using the multi-period Geske–Johnson model that assumes endogenous default barriers. Second, based on the arbitrage performance of 369 North American obligators from 2004 to 2008, we find that the extended Geske–Johnson model is more suitable than the CreditGrades model for exploiting the mispricing between equity prices and credit default swap spreads. Finally, the Geske–Johnson model also performs well in extreme market condition, such as the financial crisis around 2008.
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Notes
Chen and Panjer (2009) utilize jump-diffusion firm-value process and the observed credit spread to obtain the implied jump distribution. Doing so, they can remove the discrepancy in credit spreads between the structural model and the reduced-form model.
The formulas provided by Geske (1977) are incorrect and corrected by Geske and Johnson (1984). However, Geske and Johnson only presented formulas for n = 2. Here, we generalize their formulas to an arbitrary n. In addition, Eldomiaty and Ismail (2008) find that long-term and short-term debt financing play important role in determining firm’s capital structure.
High grade bonds contain more interest rate risk than credit risk.
Chen et al. (2009) find that the Constant-Elasticity-of-Variance option pricing model could be a better candidate for pricing more complicated path-dependent options or credit risk models.
Guedes and Opler (1996) find that speculative-grade firms typically borrow in the middle of the maturity spectrum, which is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation. In addition, Rauh and Sufi (2010) show that firms that are downgraded from investment grade to speculative grade simultaneously increase their usage of both subordinated bonds and secured bank debt in the 2 years after a downgrade.
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Acknowledgments
Shih-Kuo Yeh would like to thank the National Science Council, Taiwan, for financial support under the Project (NSC 98-2410-H-005-029).
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Ju, HS., Chen, RR., Yeh, SK. et al. Evaluation of conducting capital structure arbitrage using the multi-period extended Geske–Johnson model. Rev Quant Finan Acc 44, 89–111 (2015). https://doi.org/10.1007/s11156-013-0400-x
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DOI: https://doi.org/10.1007/s11156-013-0400-x