If it doesn’t work as a hedge fund strategy, try making policy with it March 7, 2014 at 12:24 pm

Capital structure ‘arbitrage’ is largely discredited as a hedge fund strategy for the rather good reason that a lot of people lost a lot of money on it. An arbitrage, remember, is supposed to involve a risk-free profit. But using the Merton model or its variants to ‘arbitrage’ between different parts of the same companies’ capital structure didn’t work very well — or, at least, it worked well until it didn’t. One of the problems (aside from various liquidity premiums embedded in prices) is that the first generation of these models assumed that the value of a firm’s assets follow a random walk with fixed volatility: which they don’t. In fact it has been known for over two decades that the PDs backed out from Merton models are far too high, something that KMV try to fix with some success at the cost of what might kindly be termed ‘pragmatic adjustments’. Now there may well be capital structure arbitrage models which don’t have these first generation problems and don’t involve arbitrary adjustments, but they are not well known (not least because if you had one that worked, you would want to use it to trade rather than to burnish your academic credibility).

There is an exercise by the US Government Accountability Office to determine how much lower big bank borrowing costs are due to expectations of government bailouts. Stefan Nagel suggests on Bloomberg that there is a risk that, by using a simple Merton-type model, the GAO will “underestimate both the banks’ proper borrowing costs and the implicit subsidy they receive from taxpayers”. True, there is. But there is also the risk that they will overestimate it, not least because as we noted above, models like this are flawed, and they tend to overestimate PDs. I absolutely think that taxpayers deserve to know what the implicit subsidy they are providing to big banks is worth – but by the same token, I think they deserve to know the model risk in those estimates. Scaremongering to suggest that the estimate will necessarily be too low is not helpful here.

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