Capital structure arbitrage
KeywordsMerton model ; Barrier options ; Vega Hedge ; Credit default swap ; Capital structure arbitrage ; Option pricing ; Implied volatility
This thesis presents a valuation model of financial derivatives related to securities with probability of default. Specifically, using the Merton model, this thesis studies an empirical (synthetic) valuation of CDS. Furthermore, it proves that the main driver of the pertinent arbitrage strategy should be to trade the CDS against the equity implied volatility and not the stock itself. The analysis shows that the key parameter is volatility. In order to maximize the sensitivity to volatility, the deep out of the money option implied volatilities are proposed. This thesis compares the theoretical price of CDS against its derived synthetic price and shows whether opportunities for arbitrage exist. Additionally, by conducting representative case studies, we describe the strategy we need to follow in order to hedge the volatility risk versus the risk that emerges from exposure to underlying equity itself.