I saw the following trade strategy (from UBS) for a high volatility name (monoline insurer): Sell 1 year puts (long stock), Use put proceeds to buy CDS (short credit) Advantages: NO upfront funding requirements, if equity goes down, most likely benefit from CDS widening and vice versa. Are there any scenarios where the equity could go down and the CDS won’t widen (buyout at the distressed equity levels)? How do you model the payoff scenarios? Any thoughts?
There’s a mountain of academic literature on this stuff, but it’s just not an especially interesting cap structure trade. One example is http://faculty.haas.berkeley.edu/bednarek/summer_paper_v11.07.pdf The equity could go down for a billion reasons and not have the CDS widen much or at all. The biggest is just a market decline that takes the stock with it. Credit spreads tend to widen when markets go down, but it’s nothing like a sure bet.
In this case the big question of course is raising capital and maintaining the AAA rating. So, it’s easy to see a scenario where a monoline slashes its dividend and raises a huge slug of highly dilutive equity capital. This could certainly lead to a rally in CDS and a sell-off in the stock. However, it’s not assured that this will happen, as mainy financial stocks have rallied after receiving dilutive capital infusions and announcing dividend cuts in recent weeks, as the market seems more concerned with capital than dilution / dividends (rightly so). But it could happen depending on the severity. I don’t think a buyout at distressed levels is a worry here. This business model only works with a AAA rating, so anyone reasonably interested in scooping up a monoline would have to have a strong balance sheet and the ability to capitalize its target. Would probably lead to tightening in my opinion. That sounds like a trade research is hawking but their prop desk would never put on. Could be wrong, but I agree that it isn’t hugely compelling.
Thanks JDV and BN. Any thoughts on how to model the payoffs (was thinking of applying the strategy to other names - WaMu, CIT etc).