(or its debt outstanding or liability).In other words, as soon as the bond issuer finishes selling the bond, itbecomes short in the market (or long in the rate). If, subsequently, themarket rallies or the rate decreases, the bond issuer will incur (but notnecessarily realize) a loss, as the PV of its debt outstanding or liabilitywill increase. Or, to put it in another way, if the issuer were to issue thebond at the time when the market rallies or the rate decreases, it can issuea similar bond with a lower coupon.58To hedge this, the bond issuer can long a receiver swap or long themarket (or short the rate) in the hedge. The economic cost of the hedging is that the bond issuer gives up on the benefit when the market sellsoff (or the rate increases). This hedging strategy is especially importantin a bullish market when, in the future, the market is more likely to go upthan down (or the rate is more likely to go down than up) in the realworld probability measure.This hedging strategy essentially converts (or swaps) the originalfixed-coupon bond into a floating-coupon bond, or, more precisely, asimple LIBOR floating bond plus a fixed-coupon leg or annuity leg (or astream of coupon cashflows). Since the fixed coupon in the annuity legis the funding spread (which is typically much less than the originalfixed-coupon),the original bond plus the swap has a much smaller sensitivity to the yield curve movement or has a much smaller duration andPVO1. This is due to the fact that the simple LIBOR floating bond ispriced (almost) at par at any coupon reset date5’ and the much reducedcoupon for the annuity leg).
’*
A coupon bond is typically structured by setting its coupon and other parameters suchthat its PV is close to par at the time of issuance. The coupon that makes the bond PVexactly the same as par is calledpar coupon.59 This means that, from the perspective of computing the duration or PVOl, a simpleLIBOR floating bond, no matter what its final maturity is, is the same as a zero-couponbond (with the same principal) maturing at the next coupon accrual start date.
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Martingale Arbitrage Pricing in Real Market
Chapter 2
This does not mean that the bond issuers would always want to longa receiver swap (or long the market). If a bond issuer plans to issue abond in the future, it may desire to hedge against the future market selloff (or the rate increases), as, in this case, it will need to issue the bond ata higher coupon. In other words, before the bond issuer sells the bond, itis actually long in the market (or short in the rate), opposite to the previous case.Thus, to hedge this or to lock in a coupon, the bond issuer can shortthe market or long a forward starting payer swap (typically cash settled).The economic cost of the hedging is that the bond issuer gives up on thebenefit when the market rallies (or the rate decreases). This hedgingstrategy is especially important in a bearish market for locking in lowercoupons when, in the future, the market will more likely to go down thanup (or the rate will more likely to go up than down) in the real worldprobability measure. This also helps to establish a two-way swap market. This forward starting swap is typically cash settled and typically hasmuch less counterparty credit risk than the physically settled ones.2.4.2
Callable Bonds and Cancelable IR Swaps
Another common and related strategy of a bond issuer is to issue a callable bond whereby the bond issuer has the option to call or purchaseback the bond at a predetermined price (typically par) and at predetermined dates (typically close to the coupon payment dates). Thus, thisoption is a Bermudan option. In other words, in this case, the bond issuer has bought Bermudan option (implied) volatilities from the bondholder, and thus needs to pay for them typically by paying a higher coupon as compared to a non-callable bond. This is one of the simpleststrategies of coupon or yield enhancement for satisfying the investors’demands for higher (potential) coupons or higher (potential) returns.The economic value for the coupon enhancement comes from thefact that this option allows the bond issuer to hedge against the marketrally (or the decrease of the rates), in which case, the bond issuer canoptionally call back the bond at par and issue a new bond with a lowercoupon. From the bond holder’s perspective, the economic value comesfrom the fact that the bond holder gives up some of the upside potentialsif the market rallies. For instance, if the rate is low enough, the bond willbe called back (at par) and the bond holder will need to reinvest at alower interest rate, which is termed as the reinvestment risk. Even beforethe bond is called back, the bond holder can have a disadvantageous
Sec. 2.4
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negative convexity at a low rate.The (implied) volatilities that the bond issuer bought can be quitevaluable and can be equivalent to a coupon enhancement as much as afew hundred basis points. In order to monetize (or convert to cash) thevolatilities bought, the bond issuer typically sells the volatilities to adealer by entering a cancelable receiver swap with a dealer, i.e., a receiver swap (the same as before) with the dealer having options to cancelthe swap (possibly with exercise cost). From the dealer’s perspective,this is a cancelable payer swap.This also helps the bond issuer handle the call decision. More specifically, when the dealer cancels the swap is essentially when the bondissuer should call back the bond (unless the dealer does not exercise optimally).The callable bond issuers are natural major suppliers of the Bermudan volatilities. The market tends to be one-sided with more supply ofthe Bermudan volatilities than demand, which is the main reason for theBermudan volatilities to be relatively cheaper than the European volatilities. There is typically an initial non-call period within which the bondcannot be called. For instance, a 30 year bond that cannot be calledwithin the first 2 years is termed as 30 non-call2 (or 30NC2).2.4.3
Examples of Practical Compkations
All the above examples may appear to be simple to an experiencedreader. However, practically, there are significant complications evenfor these simple examples.The first complication, as the reader may be able to guess by now, isthe counterparty credit risk, which, as we pointed before, makes anyOTC derivatives instrument defaultable or hybrid with credit or, in caseof credit derivatives, a compound credit derivatives instrument. Not onlydo we need to properly value such default premium (or credit charge orCVA), we also need to properly handle its impact on hedging and theearly exercise decision of the underlying OTC derivatives, which weshall discuss in more details in Chapter 8.As another complication, it is important to point out that by enteringa generic interest rate cancelable swap with a dealer (which is the casefor the above examples), an issuer can hedge away the risk in the genericinterest rate (or its volatility), but the issuer does not properly hedge itsfunding spread or credit spread risks (or their volatilities), especially forlower credit rated issuers. For instance, if a high yield issuer issues a
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Chapter 2
simple fixed-coupon callable bond, it may want to call back the bondwhen its funding rate declines and issue another one with lower fundingrate or par coupon (which is an aggregation of the generic interest rate,such as the corresponding par swap rate and its credit spread).Let’s perform a simple scenario analysis. More specifically, let’sconsider the scenario whereby the decline of the funding rate or par coupon is the result of a significant decline of the credit spread with the generic interest rate unchanged or slightly increased. In this case, the issuermay want to call back the bond, but the dealer with the cancelable generic interest rate swap may not want to cancel the swap. It is interestingfor the reader to think more about this and about what the issuer can doshould this situation happen, who would benefit from this, and whattypes of trades the issuer can enter into to prevent this from happening.There is yet another complication related to the counterparty creditrisk. More specifically, some investors demand AAA rated bonds ornotes, and the AAA rated issuers demand to swap with AAA dealers.Typically, dealers are A or AA rated. So a common strategy for a dealeris to establish an AAA subsidiary for the purpose of swapping with AAAissuers. Such AAA subsidiary is typically a bankruptcy-remote SPV(Special Purpose Vehicle) or, more specifically, a DPC (DerivativesProduct Company).This is quite similar to the situation of a CDO (Collateralized DebtObligation) whereby with, e.g., a pool of BBB or lower rated assets, anAAA tranche can be established.There are other types of bankruptcy-remote SPVs, such as CDPCs(Credit Derivatives Product Companies).2.4.4
Structured Notes and Exotic Derivatives
In addition to the simple non-callable and callable bonds discussedabove, there are also significant amounts of issuance of the structurednotes with various exotic features embedded in the coupon for yield enhancement and funding cheapening. Typically, the coupons are bothcapped and floored and can include exotic cap/floor features, such asperiodic caps/floors. Often times, these notes are callable for furthercoupon or yield enhancement. The coupon enhancement in this case canbe much more significant than in simple bonds. Some of the structurednotes can pay initial coupons of about 10% or more.The economic value typically comes from the risk that the note maypay very low or no coupons in the future under certain market condi-
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tions. As pointed out before, the trading is typically motivated by thedifferent views of the arbitrage models and forecasting models or thedifferent probabilities for these market conditions to occur as predictedby these models.Typically, the issuer needs to swap the exotic coupons (that is alsotermed as the exotic coupon leg) with a dealer in exchange for receivingsimpler cashflows, such as LIBOR plus a (funding) spread, which is alsotermed as the funding leg. This essentially allows the note issuer tohedge away almost all the risks associated with the exotic coupons andthe callable feature (such as the risks in volatility, forward volatility,volatility skew and smile, forward volatility skew and smile, correlation,and forward correlation, etc.), except for the counterparty credit risk.This also helps the note issuer in terms of operations or making the calldecisions. Essentially, when the dealer cancels the swap is when the noteissuer should call the note. The exception is when the dealer does notexercise optimally.Thus, the structured note business is closely tied to the developmentof exotic and hybrid derivatives instruments or swaps. Some of the subtleties introduced by the counterparty credit risk also apply in thesecases.Another yield enhancement (or trade cheapening) measure is, insteadof making a note callable (which represents a Bermudan option), to makethe note (mandatory) knock-out if a certain interest rate is lower than acertain barrier. A note can also be made putable or knock-out if a certaininterest rate is higher than a certain barrier. In contrast to the yield enhancement (or trade cheapening), these are at cost to the note holder.Some simple and common exotic coupon structures include inversefloaters, range accruals (RA), capped floaters, etc. If these coupons depend on absolute values of LIBORs, CMS (Constant Maturity Swap),and CMT (Constant Maturity Treasury) rates, then these coupons mainlytake positions in the level or the first principal component of the yieldcurve movement and its volatility.If these coupons depend on CMS spreads (such as 20 year CMS rateless the 2 year CMS rate), then these coupons mainly take positions inthe slope or the second principal component of the yield curve movementand its volatility. In the upward sloping yield curve environment, theseare typically steepeners whose value increases with the steepening or theslope of the yield curve. The investors’ view is that the yield curve in thefuture will be roughly as steep as the yield curve today. The economic
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value comes from that the dealers price in and pass to investors morevalues in the yield curve inversion than the risk of the yield curve inversion that the investors perceive under the real world probability measure.Simple examples of this type include (callable) CMS spread floaters and(callable) CMS spread range accruals.There are also coupon structures that mainly depend on the volatilityof the yield curve, such as straddle or strangle of cliquets.In addition, the coupon (and/or the notional) can depend on variousinterest rate indices, such as municipal (muni) and treasury indices, foreign interest rates, as well as other quantities, such as inflation and mortgage repayment rate.These coupons can also be in arrears, i.e., reset and paid at (roughly)the same time. As we mentioned before, these coupons can be bothcapped and floored and can include exotic cap/floor features, such asperiodic caps/floors.In recent years, new types of structured notes, such as TArget Redemption Notes (TARN) and snowball notes were developed. For moremarket information, the reader can refer to http://www.MTN-i.com.60A TARN is a note that pays a guaranteed total or cumulative couponpayment (for unit notional), such as 15%. In other words, if the cumulative coupon is reached before the maturity or the redemption date of thenote, then the note is early redeemed (with the principal paid back) at thecorresponding coupon payment date. Otherwise, at the maturity of thenote the principal is paid back and the cumulative coupon is made whole.The TARN feature can be applied to almost any structured notes and exotic swaps.Essentially, a TARN has a barrier option knocking out based on thecumulative coupon (with path dependent rebate) and is a highly path dependent derivatives instrument that depends on many volatility skew andsmile points. It essentially converts the uncertainty in the amount of cumulative coupons to the uncertainty of time-to-redemption.The motivation for this type of trades is that the investors think andhope that the redemption would occur sooner (implying higher yield-toredemption) than what the dealers think and price in.In other words, whether or not a TARN is early redeemed dependingon the following barrier indicator at every TARN look-up time ti or
6o Registration is required. MTN stands for Medium Term Note, which is a rapidly developing debt market for structured notes.
Sec. 2.4
77
Trading Opportunities and Strategies
period i,
IN
(2.4)
=o
where C, is the target cumulative coupon, ci the coupon rate for periodi,the corresponding accrual period, and N denotes the last period.Thus, ciq. is the unit coupon payment or the coupon payment for unitnotional for period i if the TARN is not early redeemed, which we shalldenote as Ci. By convention, all the coupon payments should be nonnegative, thus, the above equation can be rewritten as
IN
=o
More specifically, if Zi is 1, then the TARN continues with a unitcoupon payment of c i s . . Otherwise, i.e., if Zi is 0, then the TARN isearly redeemed (or redeemed at the final maturity) with a unit coupon
( -xi-'c .8.,0). Equivalently,
payment of max C,
j=o
ci= z , c , ~+(1-zi)maxThe fact that
(
max C, - c r o c j 8 '0)j = zi-' (c,-
xi-' .s.)j=O cJ
J
(2.7)
can help us think intuitively about the unit coupon payment in terms ofthe previous one. In other words,
78
Martingale Arbitrage Pricing in Real Market
=Ii-l(Iici8i+ ( l - I i ) ( c c
-z?j=O
c.8.))J J
Chapter 2
,
(i=N)Typically, if the TARN leg is knocked out or early redeemed, thenall the other legs in the swap trade are also knocked out. Simple examples of TARNs include TAR inverse floaters and TAR range accruals.The snowball is a feature to link the current coupon with the previous coupon. Thus, if the previous coupon is high, then the current coupon tends to be high. In other words, if the views of the investors arecorrect at any period, then the benefit is carried forward. In case the previous coupon is low, the current coupon can still possibly be high.More specifically, the coupon rate (for period i ) ci is given byci = max (ci-l + Si,0) ,
(2.9)
where Si is typically given by
6.I = s.I - R.I 7
(2.10)
where si is spread and Ri is a certain interest rate such as a LIBOR rate(in arrears).A snowball can also be structured as a bearish note or swap by setting
6I . = R1. - s .I ’
(2.11)
where Ri typically is a CMS/CMT rate. In this case, it is a termed assnowbear.The coupon can be capped and floored as follows,ci-l
+ si,0) ,cf ) ,cf ) ,
(2.12)
where c: is the cap and cif the floor, both are typically non-negative.Intuitively, the coupon receiver is short the cap and long the floor.
Sec. 2.4
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Snowballs can also be callable and have a TAR feature. A snowballwith a TAR feature is also termed as snowblade.There are also (callable) zero swaps whereby all the coupons are cumulated to and paid at the final maturity (or the early exercise date).This is a popular trade type among muni issuers for hedging their (callable) zero-coupon muni bonds. One of the motivations for issuing zerocoupon bonds is to simplify the management of cashflows or cashflowliquidities (and to eliminate the need of defaulting on the coupon payments).Furthermore, there are significant business opportunities for hybridderivatives whereby the coupon (andor the notional) is linked with FX(including NDF and NDO), equity, credit, and inflation, as well as implied and realized volatilities. We shall provide examples of some ofthese through out the book.2.4.5
IRIFX Hybrid Notes and Derivatives
As we indicated before, similar curve strategies can also be derived andapplied to the FX market. According to the interest rate parity (from anarbitrage model), large interest rate differentials between two currenciesresult in a steep forward FX curve. Similar to before, in an arbitragemodel, the spot FX rate “climbs” up along the forward FX curve. On theother hand, a forecasting model typically predicts that the future FXcurve is close to stationary or “slides” in parallel to today’s forward FXcurve.With the low interest rate of Japanese Yen or JPY, the FX rates between JPY and many other currencies, such as JPYKJSD (JPY value of 1USD) or JPY/AUD (JPY value of 1 AUD),61 exhibit steep forward FXcurves. More specifically, in an arbitrage model, future JPY is expectedto become very strong (or lower JPYAJSD and JPY/AUD FX rates),whereas in a forecasting model, future JPY is expected to more or lessremain at its current level.Thus, a yield enhancement or relative value strategy for investors isto long (or invest in) USD or AUD treasury bonds to earn higher interestrate payments and fund such position by shorting JPY treasury bonds (orborrowing fund at lower interest rate). In an arbitrage model, the benefit6’ The FX rate convention can be confusing.
The convention that we use for the FX rateof X N is the value in currency X of 1 unit of currency Y. One way to double check isthat JPYNSD and JPY/AUD should be much greater than 1.
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Martingale Arbitrage Pricing in Real Market
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of the interest rate differential is offset by the strengthening of JPY in theforward market, whereas in a forecasting model, such benefit is expectedto be realized. In other words, a dealer would price and sell this structureat much lower value than perceived by an investor, which can result invery significant yield enhancement for the investors (and significantprofit for the dealers at the same time). This is termed as a RDC (Reverse Dual Currency) strategy.The popular (callable or knock-out) PRDC (Power Reverse DualCurrency) note and swap is based on such strategy. It provides the convenience of trading in one transaction, in one currency, and with leveraging. Further yield enhancement can be achieved with callable or knockout features.From the perspective of a Yen investor, the coupon rate (for period i )ci is given by(2.13)where C: is (a multiple of) the foreign (USD or AUD) coupon rate, c:(a multiple of) the domestic (JPY) coupon rate, FXi the FX rate in termsof Yen value of a unit foreign currency, all for period i. FX, is a prespecified or initial FX rate for converting the foreign currency notional tothe domestic currency (JPY).Similar to before, the coupon is typically capped and floored as follows,(2.14)
where c,c is the cap and c;' the floor, both are typically non-negative.Intuitively, the coupon receiver is short the cap and long the floor.This is essentially a long dated FX trade whereby the investor has ashort position in Yen (or receivables in the foreign currency and payablesin Yen). More specifically, if Yen strengthens relative to the foreign currency (or lower FX; value), then the investor will lose value on thetrade. This is similar to the risk profile of Japanese exporters (with shortpositions in JPY and long positions in foreign currencies).On the other hand, if Yen weakens relative to the foreign currency
Sec. 2.4
Trading Opportunities and Strategies
81
(or higher FXivalue), then the investor will gain value on the trade untilit is close to the call exercise boundary or the knock-out barrier, when thenegative convexity can occur.Callable and knock-out PRDCs contain FX options and, thus, arealso sensitive to FX volatility skews and smiles, as well as FX and interest rate correlation and interest rate volatilities. The cap on the couponand the call option are options of domestic currency (Yen) put and foreign currency call. The floor on the coupon is an option of domestic currency (Yen) call and foreign currency put. The investor is short on thecap on the coupon and the call option and long on the floor on the coupon. The dealer assumes the opposite positions. The investor is typically short on the barrier, if the knock-out occurs when the investor is inthe money (or when Yen weakens in this case).Target redemption (TAR) can also be applied to a PRDC to structurea TAR PRDC.PRDCs can also be structured with the foreign currency being anemerging market currency with a high interest rate. One subtlety is thatthe value of an emerging market currency is highly correlated with itscredit quality and tends to exhibit significant jumps or sudden devaluations upon default. This is essentially a credit/FX/IR hybrid instrument.This may not work for emerging market currencies that are managed bythe government and are pegged to other currencies (such as USD, EUR,JPY).Other similar hybrid instruments include those linked to other financial quantities or indices, such as equity linked notes or swaps, inflationlinked notes or swaps, mortgage prepayment linked notes or swaps, andemerging market currency linked notes or swaps, volatility linked notesor swaps. Principal protected (callable) equity linked notes are attractiveto various funds that are not allowed to directly take the risks in the equity market.Another motivation for the need of hybrid instruments is for themanagement of asset and liability mismatch of an entity in that the assethas a long position in one market and the liability has a short position inanother market. For instance, if the asset has a long position in the equity market and the liability has a short position in the interest rate market, then there is a need to hedge against the equity market selling-offand the interest rate market rallying at the same time. One possibility isto buy an equity index put knocked in when the interest rate is lowenough.
82
2.4.6
Martingale Arbitrage Pricing in Real Market
Chapter 2
Asset Swaps and Repackaging
In addition to investing in PRDC notes and other structured notes, aninvestor can also invest in asset swaps to achieve the same payoffs (except that the counterparty credit risk is different). An asset swap is apackage of an asset combined with a swap and the swap can be eithercredit linked or not linked to the asset. This essentially repackages anasset into another asset (e.g., with different coupons).For instance, an investor may like certain bonds, such as governmentbonds for their high credit worthiness and liquidity, but does not liketheir plain fixed coupons. Then, the investor can enter into an asset swapwith a dealer by buying the bond and swapping the bond coupons intostructured coupons, such as PRDC coupons.In an asset swap with a defaultable bond, the investor typically buysthe defaultable bond and swaps the bond’s fixed coupons into floatingcoupons with a credit spread or the asset swap spread. Typically, theswap is not credit linked to the bond and should the defaultable bond default, the IR swap is still effective. This allows the investor to take onlythe credit risk in the bond, but not much the interest rate risk.There are also hybrid asset swaps on defaultable underlying assets,which can be a tranche of a CDO/CSO, with coupons swapped intostructured IR coupons and the swap is typically credit linked to the underlying asset. This allows yield enhancement from both credit andstructured IR. These are more or less the same as credit linked structuredIR notes.We shall discuss more credit hybrids in the next section.
2.4.7
Credit Hybrid Derivatives
As we pointed out before, due to the counterparty credit risk, OTC derivatives with high yield counterparties or some emerging market counterparties naturally become credit hybrid derivatives or compound creditderivatives. For instance, an IR derivatives instrument becomes a defaultable or credit/IR hybrid derivatives instrument, an I W X hybrid derivatives instrument becomes a defaultable or credit/IWX derivativesinstrument, and a credit derivatives instrument becomes a compoundcredit derivatives instrument. The same is true for equity, FX, commodity, and other derivatives. The intermediation is a simple way of tradingonly the counterparty credit risk in OTC derivatives with the market risksbeing completely hedged.
Sec. 2.4
Trading Opportunities and Strategies
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A particular example is a cross-currency IR swap with an emergingmarket sovereign entity. The typical situation is that the emerging sovereign entity needs to issue external debt denominated in a (strong) foreigncurrency (such as USD), but would like to fund the debt issuance withtheir local currency.To do so, the emerging market sovereign entity can enter into across-currency IR swap with a dealer whereby the emerging market sovereign entity receives the (strong) foreign currency (such as USD, tomatch its bond coupon payment) and pays its local currency (eitherphysically or through NDF).One question of great importance to the dealer when trading with alower credit rated counterparty, such as an emerging market entity, is thecredit risk that the dealer needs to manage. The reader may want to thinkabout whether this cross-currency IR swap is a wrong-way or right-waytrade (in terms of credit risk or exposure) for the dealer.In this case, first of all, there is a strong correlation between the market value of this trade and the credit quality of the emerging market sovereign entity due to the strong correlation between the credit quality ofthe emerging market sovereign entity and the value of its local currency.For instance, upon the default of the emerging market sovereign entity,its currency will devaluate significantly, and, thus, the dealer (receivingthe local currency and paying the (stronger) foreign currency) will mostlikely owe money to the emerging market sovereign entity, thus, will notincur credit loss. Therefore, this is a right-way trade for the dealer.There is, nonetheless, significant market risk for the dealer to manage.There are also credit hybrid or credit contingent derivatives whosepayoffs are explicitly linked to credit events and are documented on tradeconfirms.The credit event typically is a default event, but can be other eventssuch as credit rating change. In an equity default swap (EDS), the contingent event is the equity price being below a certain level, typically alevel much lower than the spot equity price. Essentially, an equity default swap is a series of deeply out-of-the-money equity put options.Examples of this category of credit hybrid or contingent derivativesinclude CCDS and credit extinguishers. Broadly speaking, the creditlinked note (CLN), and notes with rating-dependent coupons also belongto this category.A CCDS is a contingent CDS whose notional is contingent on orlinked to the PV of an OTC derivatives instrument. It provides the credit
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Martingale Arbitrage Pricing in Real Market
Chapter 2
protection (to the protection buyer) on the OTC derivatives instrument byproviding the replacement of the same instrument upon the default of thereference credit. In other words, it is an OTC derivatives instrument witha knock-in feature upon the default of the reference credit. A credit extinguisher is an OTC derivatives instrument with a knock-out featureupon the default of the reference credit with zero rebate or a rebatelinked to the face value of the defaulted bonds of the reference credit.The typical motivation of a CCDS is to trade the counterparty creditrisk on an OTC derivatives instrument or to provide a static hedge forsuch counterparty credit risk. This is more flexible than the intermediation. The typical motivation of a credit extinguisher is to achieve funding cheapening.With a credit extinguisher, one can actually structure a trade wherebyone pays a premium to one’s counterparty due to the counterparty’s likelihood of default.As a continuation of the previous example whereby the emergingmarket sovereign entity pays the local currency and receives the(stronger) foreign currency. A credit extinguishing feature can be addedto the trade whereby if either party defaults, then the trade is knocked outwith zero rebate. In this case, the dealer can afford to pay a premium tothe emerging market sovereign entity and the dealer can make back thepaid premium by selling credit protection on the emerging market sovereign entity, The reader may want to fill in more details based on whatwe discussed in the previous example.Some brokers are working on sourcing liquidity for the market forsome of these derivatives instruments. For more information, the readermay want to refer to, e.g., http://www.SwapMeCredit.com.Some of these are the same as establishing a (synthetic) derivativesrep0 market or a (synthetic) secured derivatives fimding market, whichcan result in lower funding cost for OTC derivatives.2.4.8
Capital Structure Arbitrage
While a particular market (such as a fixed-income market or an equitymarket) is becoming more and more efficient, there seem to be crossmarket arbitrage or relative value opportunities. For instance, the capitalstructure arbitrage strategy tries to arbitrage or capture the relative valuesbetween the debt and the equity market and across other capital structures.As we know, the stock of a firm is a (perpetual down-and-out) call
Sec. 2.4
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85
option on the firm’s value or asset. The bond of the firm,on the otherhand, is a default-free bond plus a short position of a (down-and-in) putoption on the firm’s value (with the put option representing the defaultrisk). This provides ar