Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage

Giovanni Calice, Jing Chen and Julian M. Williams

The European Journal of Finance, 2013, vol. 19, issue 9, 815-840

Abstract: In a naked credit default swap (CDS) position, a party pays an income stream to a seller of protection to swap away default risk on an underlying defaultable security without actually holding this reference instrument. Using mark-to-market returns on a large cross section of CDS positions, held independent from their reference entity, we implement a novel test to establish whether their inclusion in an optimised portfolio is replicable by a large set of alternative assets. Overall, we find significant excess returns of over 28% per annum against an optimised benchmark, we speculate that it is these characteristics that could be driving a bubble in the CDS market.

Date: 2013
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DOI: 10.1080/1351847X.2011.637115

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