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> What are you going to pay the interest with, your negative profits? Capital structure arbitrage means that there's a market for any public company's junk bon

> What are you going to pay the interest with, your negative profits? Capital structure arbitrage means that there's a market for any public company's junk bonds regardless of their balance sheet position. What matters is the likelihood of collapse, as measured by put option pricing. The logic is pretty straightforward. You buy the bond, put options on the common equity, and short the appropriate treasury futures contract. If the company fails to pay the bond as agreed, you get your money back via the put options. If they don't, you collect the excess premium of the junk bonds, minus the cost of delivering the short treasury futures contracts and the premium paid for the put options that are expiring worthless. At no point does the actual creditworthiness of the company matter in this analysis. The arbitrageurs need not care. If the equity market believes that they have a future, they're either right and you get paid back on the junk bonds, or they're wrong and you pick their pocket shorting the company.

evandijk70 7y ago
This is clearly not true, because if any company can find a market for their bonds, no company would ever need to go bankrupt. Puts would be prohibitively expensive if the company is likely to go bankrupt.
- ThrustVectoring 7y ago
  There's a market, there's not a market of unlimited size (or even one large enough to make a meaningful difference to solvency). As one upper limit, if you borrow literally every publicly available share and sell it short, that limits you to hedging bonds up to the total market capitalization of the company.
lordnacho 7y ago
What's the sticking point here? What if you have competitors doing the same arb? Seems like it's not a pure guaranteed arb. What parameters are pushed to the margins? I'm an ex derivatives trader so you can go into details.
- ThrustVectoring 7y ago
  If you squint and look at a corporate bond funny, it has an asymmetric payoff profile that looks an awful lot like selling a put option on common equity. If the company does badly you can lose up to a certain maximum, and if it does well you get to book a little bit of profit. Everything else is relatively unimportant bookkeeping and technical details that I am not familiar with because this is a member of "things I read about and found interesting and understood", not "things I have done in the market to make money". You can take on the equity risk either by delta-hedging it and shorting the underlying stock like you would when selling options, or you can buy options written by people who likely end up doing delta hedging. On the bond side, you can either buy the underlying and hedge interest rate risk in the treasury futures market, or you can take aim at the credit default swap market and buy/sell the credit spread directly. Either way, you're basically just modeling the relationship between different prices in a company's capital structure and noting how much money your combined position makes if prices converge at either corporate success or bankruptcy. > What's the sticking point here? What if you have competitors doing the same arb? You have competitors doing the same arb, there's no free money to be made. My point is that when a company decides to sell bonds, there are people who will buy it based off the solvency risk implied by equity option prices. > Seems like it's not a pure guaranteed arb. It's not, but the side I described generally doesn't have lurking steamrollers to run you over. Model breakdown is a thing that happens, especially during crises, and especially if you slightly under-hedge to avoid paying carry costs for the "equity does badly but no bankruptcy" profit case. Plus, there's no guarantee that buying put options or shorting common equity will make a profit if the underlying company goes kaput (for example, if trading is suspended in the underlying, your options can expire or your short position can charge you borrow fees while you are unable to legally purchase shares to deliver into the contract or to close your short).
xchaotic 7y ago
“ put options on the common equity” you mean index or that company’s? Because you can’t buy options for Airbnb as it’s not IPOd yet
- ThrustVectoring 7y ago
  I mean you can't, but the secondary market for large private firms is rather well developed for the big players.
H8crilA 7y ago
I meant when you're a (sensible) startup founder that wants to see the fruit of their labor, not when you are a fund manager. We're both correct, just looking from supply vs demand points of view.

evandijk70 7y ago

This is clearly not true, because if any company can find a market for their bonds, no company would ever need to go bankrupt. Puts would be prohibitively expensive if the company is likely to go bankrupt.

ThrustVectoring 7y ago
There's a market, there's not a market of unlimited size (or even one large enough to make a meaningful difference to solvency). As one upper limit, if you borrow literally every publicly available share and sell it short, that limits you to hedging bonds up to the total market capitalization of the company.

lordnacho 7y ago

What's the sticking point here? What if you have competitors doing the same arb? Seems like it's not a pure guaranteed arb. What parameters are pushed to the margins? I'm an ex derivatives trader so you can go into details.

ThrustVectoring 7y ago
If you squint and look at a corporate bond funny, it has an asymmetric payoff profile that looks an awful lot like selling a put option on common equity. If the company does badly you can lose up to a certain maximum, and if it does well you get to book a little bit of profit. Everything else is relatively unimportant bookkeeping and technical details that I am not familiar with because this is a member of "things I read about and found interesting and understood", not "things I have done in the market to make money". You can take on the equity risk either by delta-hedging it and shorting the underlying stock like you would when selling options, or you can buy options written by people who likely end up doing delta hedging. On the bond side, you can either buy the underlying and hedge interest rate risk in the treasury futures market, or you can take aim at the credit default swap market and buy/sell the credit spread directly. Either way, you're basically just modeling the relationship between different prices in a company's capital structure and noting how much money your combined position makes if prices converge at either corporate success or bankruptcy. > What's the sticking point here? What if you have competitors doing the same arb? You have competitors doing the same arb, there's no free money to be made. My point is that when a company decides to sell bonds, there are people who will buy it based off the solvency risk implied by equity option prices. > Seems like it's not a pure guaranteed arb. It's not, but the side I described generally doesn't have lurking steamrollers to run you over. Model breakdown is a thing that happens, especially during crises, and especially if you slightly under-hedge to avoid paying carry costs for the "equity does badly but no bankruptcy" profit case. Plus, there's no guarantee that buying put options or shorting common equity will make a profit if the underlying company goes kaput (for example, if trading is suspended in the underlying, your options can expire or your short position can charge you borrow fees while you are unable to legally purchase shares to deliver into the contract or to close your short).

xchaotic 7y ago

“ put options on the common equity” you mean index or that company’s? Because you can’t buy options for Airbnb as it’s not IPOd yet

ThrustVectoring 7y ago
I mean you can't, but the secondary market for large private firms is rather well developed for the big players.

H8crilA 7y ago

I meant when you're a (sensible) startup founder that wants to see the fruit of their labor, not when you are a fund manager. We're both correct, just looking from supply vs demand points of view.