MS&E444 Spring 2011 – Project Proposals

Project background: one common strategy within the capital structure relative value umbrella is trading credit versus equity. Credit and equity are both claims on the assets of a company. Debt securities typically pay a fixed coupon to the holder as long as the company does not default, but offers no additional upside if the company’s performance improves and its assets become more valuable. On the other hand, equity offers a residual claim on the assets of the company once debt-holders are paid, in addition to potentially offering cash flows in the form of dividends. As a company’s overall performance deteriorates, the prices of its equity and debt fall, as its future earnings potential falls and its probability of default rises. Investors who trade credit versus equity use theoretical and empirical models to think about both the “right” price of debt versus equity (and hence, when to put on a long equity, short credit trade or vice versa) and about appropriate hedge ratios for those trades.