Exploring Statistical Arbitrage Opportunities in the Term

Structure of CDS Spreads

Robert Jarrow, Haitao Li, and Xiaoxia Ye

November 2009

Preliminary

Jarrow is at the Johnson Graduate School of Management, Cornell University, Ithaca, NY 14850. Li

is at the Stephen M. Ross School of Business, University of Michigan, Ann Arbor, MI 48109. Ye is at

the Wang Yanan Institute for Studies in Economics, Xiamen University, Xiamen, China. We thank our

colleagues for helpful comments. We are responsible for any remaining errors.
 Exploring Statistical Arbitrage Opportunities in the Term
Structure of CDS Spreads
Abstract

The rapid growth of the CDS market makes it possible to speculate on the relative
pricing of the credit risk of a company across a wide range of maturities. Based on
a reduced-form model of credit risk, we explore “statistical” arbitrage opportunities in
the term structure of CDS spreads of a large number of companies in North America.
Speci…cally, we estimate an a¢ ne model for the term structure of CDS spreads of a
given company and identify mis-valued CDS contracts along the credit curve. We trade
market-neutral portfolios of mis-valued CDS contracts relative to our model, betting
that the mis-valuation will disappear over time. Empirical analysis shows that our
“arbitrage”strategy can be very pro…table. For most …rms, the Sharpe ratios are higher
than one, and for some …rms, the Sharpe ratios are even above two.
JEL Classi…cation: G00, G12, G13
Keywords: Credit default swaps, statistical arbitrage, a¢ ne models, market-neutral
strategies, hedge funds.
1 Introduction

The credit derivatives markets have experienced tremendous growth in the last decade.
According to the Bank for International Settlements (BIS), the notional value of out-
standing credit derivatives by the end of 2007 was 58 trillion dollars. The single-name
credit default swaps (CDS) are the most liquid and popular product, as they account for
more than two thirds of all outstanding credit derivatives. Though some exotic credit
derivatives, such as subprime CDOs have caused tremendous problems in the current
…nancial crisis, the vanilla CDS contracts do play important economic roles. The newly
proposed regulations, such as the establishment of central clearing house for CDS, would
help to reduce systemic risk and improve transparency in the CDS markets. Therefore,
the CDS contracts are likely to remain to be the preferred vehicle for investing, specu-
lating, and managing single name credit risk.
The rapid growth of the CDS market makes it possible to speculate on the relative
pricing of the credit risk of a company across a wide range of maturities. Though …ve-
year CDS has been the most liquid contracts until recently, nowadays a complete credit
curve (CDS spreads over di¤erent maturities) is available for many companies. As a
result, it is possible to buy and sell protections on a given …rm at di¤erent maturities.
A natural question arises in this market is whether the credit risk of a …rm is consis-
tently priced across maturities. This is an interesting question to both academics and
practitioners. From an academic perspective, one interesting issue is whether existing
credit risk models, either structural or reduced-form, can capture the rich term struc-
ture behaviors of credit spreads. From a practical perspective, one challenging issue
is whether one can design trading strategies to exploit potential mispricings along the
credit curve.
In this paper, we take an applied approach to this problem. Based on a reduced-
form model of credit risk, we explore potential “statistical” arbitrage opportunities in
the term structure of CDS spreads of a large number of companies in North America.
Speci…cally, we consider 297 …rms with continuous daily observations of CDS spreads
with maturities of 1, 2, 3, 5, 7, 10, 15, 20, and 30 years between January 4, 2005 and
December 31, 2008. We estimate an a¢ ne model of credit risk for each company based
on its term structure of CDS spreads and identify “mis-valued” CDS contracts relative
to the model. Based on the estimated model parameters, we construct a portfolio of

1
CDS contracts that are both delta- and gamma-neutral to potential changes in credit
spread. Then we would long (short) the portfolio if it is under (over) valued relative to
our model and liquidate the portfolio a week later.
We conduct both in-sample and out-of-sample analysis on the pro…tability of the
above “statistical arbitrage” strategy. In the in-sample analysis, we estimate model
parameters, construct arbitrage portfolios, and calculate trading pro…ts using all the
data. In the out-of-sample analysis, we estimate model parameters using the …rst half
of the sample, based on which we construct arbitrage portfolios and calculate trading
pro…ts using the second half of the sample.
We …nd that our “arbitrage”strategy can be quite pro…table both in sample and out
of sample. For most …rms, the Sharpe ratio of the weekly returns of this strategy is above
one. For more than half of the …rms, the Sharpe ratio can be well above two! Obviously
the CDS contracts at di¤erent maturities might have di¤erent levels of liquidity, which
are not re‡ected in their quoted spreads. There could also be counterparty risks in
CDS contracts. Our analysis does not explicitly take into account of bid-ask spreads
and various transaction costs either. Despite these concerns, the high Sharpe ratios we
document do suggest that there could be interesting “statistical”arbitrage opportunities
in the term structure of CDS spreads that could potentially be exploited.
Though a huge literature has been developed on credit risk in the past decade,
empirical studies on CDS that involves the modeling of the entire credit curve is still
pretty rare. One main reason is that until recently we do not have the data on the CDS
spreads for a wide range of maturities. Two studies that are closely related to ours are
Zhang (2008) and Pan and Singleton (2008), who estimate default risk models using
the entire credit curve of sovereign CDS spreads. One important contribution of our
paper, however, is that we are probably one of the …rst to focus on exploring potential
“statistical” arbitrage opportunities in the term structure of CDS spreads.
The rest of this paper is organized as follows. In Section 2, we discuss the a¢ ne
term structure model for credit risk. Section 3 discuses the econometric methods for
estimating the model. Section 4 discusses empirical results on model estimation and
trading performances. Section 5 concludes.

2
2 The Model

In this section, we develop a one-factor a¢ ne model for the term structure of CDS
spreads. We use only one factor to capture the dynamics of credit risk because our
principal component analysis (PCA) on CDS spreads shows that the …rst principal com-
ponent captures more than 97% of the variations of CDS spreads. Our model is similar
to that of Longsta¤ et al. (2005), Du¢ e and Singleton (1999), Du¢ e and Singleton
(1997), Du¢ e et al. (2003), and Zhang (2008). For the sake of robustness of model per-
formances (especially out-of-sample performances), we assume that credit spreads are
independent of interest rates and thus avoid estimating a model for the default-free term
structure. We obtain similar results with a two-factor a¢ ne model for the default-free
term structure, in which the credit spread is correlated with the two interest rate factors.
Speci…cally, we assume that the state variable, i.e. the default intensity ht ; follows a
square root process (CIR process) as

ht = Zt ; (1)

and
p
dZt = Z ( Z Zt ) dt + Z Zt dwZQ (t) ; (2)

where wZQ (t) is a standard Brownian motion under the equivalent martingale measure
Q.
While we only need the dynamics of the state variable under the Q measure for
pricing purpose, we need its dynamics under the P measure for econometric estimation.
Given the completely a¢ ne speci…cation of market price of risk, we model the P measure
dynamics of the state variable as

p
P
dZt = Z Z Z Zt dt + Z Zt dwZP (t) :

To compute the CDS spread, we assume a constant recovery rate. Since both the
buyer and the seller of credit protection in a CDS are exposed to counterparty risk,
the quoted recovery rates might di¤er from the real recovery rates implicit in the CDS
spreads. Therefore, unlike the common practice in the literature which sets the recovery
rate to a certain number (see, e.g., Longsta¤ et al. (2005), and Zhang (2008)), we estimate

3
the value of the constant recovery rate along with model parameters from the market
prices of CDS spreads. Under the fractional recovery of face value (RFV) framework,
which has been widely used for pricing CDS, the recovery rate and the default intensity
can be easily identi…ed jointly. To this end, we set recovery rate as

1 y = exp ( 0) ;

where 0 > 01 .
Then the CDS spread at t for a protection between t and t + equals
R t+
[1 exp ( 0 )] t P (t; u) E2 (t; u) du
St = R t+ ; (3)
t P (t; u) E1 (t; u) du

where P (t; T ) is the time-t price of a default-free zero coupon bond that matures at T ,
and
Z u
Q
E1 (t; u) = E exp Zs ds Ft ;
Zt u
E2 (t; u) = EQ exp Zs ds Zu Ft :
t

Following Du¢ e et al. (2000), we consider the “Transform”and the “Extended Trans-
form” respectively below,
Z u
Q
(w; Zt ; t; u) = E exp Zs ds ewZu Ft ; (4)
Zt u
(v; w; Zt ; t; u) = EQ exp Zs ds vZu ewZu Ft : (5)
t

Proposition 1 of Du¢ e et al. (2000) indicates that (4) has the following form:

(w; Zt ; t; u) = exp fA (t; u) + B (t; u) Zt g ;

1
The positiveness of parameter 0 ensures that y 2 (0; 1).

4
where A and B satisfy the ODEs

1
B_ (t; u) = 1 + Z B (t; u) B (t; u)2 2
Z;
2
A_ (t; u) = Z Z B (t; u) ;

with boundary conditions B (u; u) = w and A (u; u) = 0, and

h 2
i
1 1 Z +w Z
Z tanh 2 (u t) 2 ln + w 2
Z Z
B (t; u) = 2 ;
Z
Z u
A (t; u) = Z Z B (s; u) ds;
t
q
= 2 2 + 2:
Z Z

Similarly, (5) is given by

@ ( v + w; Zt ; t; u)
(v; w; Zt ; t; u) =
@ =0
= (w; Zt ; t; u) [C (t; u) + D (t; u) Zt ] ;

where C and D satisfy the ODEs

1
D_ (t; u) = Z D (t; u) D (t; u) B (t; u) 2
Z;
2
C_ (t; u) = Z Z D (t; u) ;

with boundary conditions D (u; u) = v and C (u; u) = 0, and

n h 2
io2
2 Z +w Z 2
v tanh 21 (u t) 1
2 ln + 2 v
Z w Z
D (t; u) = ;
2
w 2 2
Z Z
Z u
C (t; u) = Z Z D (s; u) ds:
t

5
 Then we have

E1 (t; u) = (0; Zt ; t; u) ;
E2 (t; u) = (1; 0; Zt ; t; u) :

In practice, following Longsta¤ and Rajan (2008), we discretize (3) as

4
X
i i
[1 exp ( 0 )] P t; t + 4 1; 0; Zt ; t; t + 4
i=1
St = 4
:
X
i i
P t; t + 4 0; Zt ; t; t + 4
i=1

3 Model Estimation

In this section, we discuss the econometric method for estimating our a¢ ne model using
CDS spreads. When implementing the model, we …rst need to back out the zero yields
from Libor and swap rates to compute the prices of default-free zero coupon bonds
P (t; T ). Then, we use these zero coupon bond prices as discount factors to calculate the
present value of the premium and the protection leg of the CDS contracts.
There are di¤erent econometric methods one can use to estimate the a¢ ne model.
Instead of using maximum likelihood, which typically assumes that certain spreads are
observed without errors and then obtains the state variables by inversion, we use the
unscented Kalman …lter (UKF) in conjunction with QMLE to estimate the credit risk
model because CDS spreads are highly nonlinear in the state variable Zt .

3.1 State Space Model

To use the UKF in empirical estimation, we re-cast our model in the framework of
state-space model. Although the transition density of the state variable in our model is
not Gaussian, by applying the UKF with QMLE, we only need to consider the …rst two
moments of the transition density. Therefore, we write down the transition equation as if
the state variable is conditionally normally distributed, as long as the …rst two moments
are intact. Duan and Simonato (1999) shows that this approximation is fairly e¢ cient
and accurate for estimating models with CIR type of state variables. Based on this

6
approach, we provide the state-space representation of the defaultable term structure
model below.
Let h be the sampling interval in our study, which is a week. Then the transition
equation for the default state variable Zt is given as

Z Z P P
Et h [Z (t)] = P
1 exp h Z + exp h Z Z (t h) ;
Z
2 2 exp h P exp 2h P
Z Z Z P 2 Z Z Z
Vart h [Z (t)] = 2 1 exp h Z + P
Z (t h) :
2 PZ Z

Let CDSt be the CDS spread for protection between t and t + : Then the measurement
equation becomes
CDSt = St (Zt ) + " ;

where " v i:i:d: N 0; v 2 and = 1; 2; 3; 5; 7; 10; 15; 20;and 30 years.

3.2 Unscented Kalman Filter

In this section, we brie‡y discuss the implementations of the unscented Kalman …lter.
More detailed discussions can be found in Harvey (1991) and Haykin et al. (2001).
One challenge in applying the Kalman …lter to estimate the credit risk model is
that the CDS spread is a nonlinear function of the state variable. One solution to this
problem, the so called extended Kalman …lter (EKF), is to consider a …rst order Taylor
expansion of the measurement equation around the predicted state Ztjt 1: Unlike the
EKF, the UKF uses the exact nonlinear function St (Zt ) and does not linearize the
measurement equation. Instead, the UKF approximates the conditional distribution of
Zt using a scaled unscented transformation. The essence of the UKF (Chow et al. (2007))
used in this paper can be summarized brie‡y as follows.
For each measurement occasion t, a set of deterministically selected points, termed
sigma points, is used to approximate the distribution of the current state2 estimates at
time t using a normal distribution with a mean vector Ztjt 1, and a covariance matrix
2
In typical UKF setting, both transition and measurement equations are nonlinear. Hence, sigma
points are needed to approximate the distribution of previous state estimates, in order to compute the ex
ante predictions of state variables’mean and variance. However, in our paper, the transition equations
are linear, so we can directly compute the ex ante predictions in the way as that in Classic Kalman
Filter, and don’t need sigma points at this stage.

7
which is a function in the state covariance matrix, PZ;t 1jt 1 (for notational clarity, we
normalize the time interval to one) and conditional covariance Vart 1 [Z (t)]. Sigma
points are speci…cally selected to capture the dispersion around Ztjt 1. They are then
projected using the measurement function St ( ), weighted, and used to update the
estimates in conjunction with the newly observed measurements at time t to obtain Ztjt
and PZ;tjt .
We start the UKF by choosing the initial values of the state variables and their
covariance matrix as their steady state values:

Z Z Z Z 2
Z0j0 = ; P0j0 = Z:
P
2 P 2
Z Z

Given Zt 1jt 1 and PZ;t 1jt 1 ; the ex ante prediction of the state and its covariance
matrix are given by

Z Z P P
Ztjt 1 = P
1 exp h Z + exp h Z Zt 1jt 1 ;
Z
2 h P 2h P
P
2
P 2 Z e Z e Z
2h Z Z Z h
PZ;tjt 1 = e Z PZ;t 1jt 1 + 2 1 e Z + P
Zt 1jt 1 :
2 PZ Z

Given an ex ante predictions of states Ztjt 1, a set of 3 sigma points is selected as

h i
tjt 1 = 0;t 1 +;t 1 ;t 1 ;

where

0;t 1 = Ztjt 1;
p q p
P
+;t 1 = Ztjt 1+ (1 + ) exp h Z PZ;t 1jt 1 + Vart 1 [Z (t)] ;
p q p
P
;t 1 = Ztjt 1 (1 + ) exp h Z PZ;t 1jt 1 + Vart 1 [Z (t)] :

The term is a scaling constant and given by

2
= (1 + ) 1;

where and are user–speci…ed constants. In this paper, we choose = 0:001 and

8
 = 2. Since the values of these constants are not critical in our analysis, we do not
provide more detailed discussions for brevity. Curious readers are referred to Chow et al.
(2007) or Chapter 7 in Haykin et al. (2001) for details.
Nonlinear transformation of the sigma points through measurement function (predic-
tions of measurements) tjt 1 is propagated through the nonlinear measurement function
St ( )
Stjt 1 = St tjt 1 ;

where the dimension of Stjt 1 is 9 3. We de…ne the set of weights for covariance
estimates as

1 1
W (c) = diag 1+ +1 2
+2 ; ; ;
2 (1 + ) 2 (1 + )
h i|
and the weights for mean estimates as W (m) = 1+
1
2(1+ )
1
2(!+ )
:
Predicted measurements and the associated covariance matrix are computed as

(m)
Stjt 1 = Stjt 1W ;
|
Py t = Stjt 1 11 3 Stjt 1 W (c) Stjt 1 11 3 Stjt 1 + V;
h i
(c) |
PZt ;yt = tjt 1 11 3 Ztjt 1 W Stjt 1 11 3 Stjt 1 ;

where V = diag v 2 ; v 2 ; ; v2 9 9
:
Finally, the discrepancy between model prediction and actual observations is weighted
by a Kalman gain t function to yield ex post state and covariance estimates as

Ztjt = Ztjt 1 + t St Stjt 1 ;

|
PZ;tjt = PZ;tjt 1 t Py t t;

where t = PZt ;yt Pyt 1 :

3.3 Likelihood Function

We assume that the measurement errors are normally distributed. Then the transition
h i|
density of S (t) = CDS1t CDS2t CDSt 30 given information set Ft 1 is a 9-
dimensional normal distribution with mean Stjt 1 and covariance matrix Pyt ; which are

9
outputs from the UKF. Thus, the transition density of S (t) can be written as

p 9q 1
1 |
ft 1 (S (t)) = 2 jPyt j exp S (t) Stjt 1 Pyt 1 S (t) Stjt 1 ;
2

then the log-likelihood function is given by

n
X n
X |
ln L _ ln jPyi j S (i) Siji 1 Pyi 1 S (i) Siji 1 ;
i=1 i=1

where n is the sample size.

4 Empirical Results

4.1 Default-free Zero Coupon Bond Prices

We back out the prices of default-free zero coupon bonds from Libor rates and plain
vanilla …xed for ‡oating Libor-quality interest rate swap rates, similar to Dai and Sin-
gleton (2003), Du¢ e et al. (2003), and Zhang (2008). Though Treasury yields have been
widely used as benchmark for risk free term structure estimation, there are concerns
that they may di¤er from the “true” risk free rates due to repo e¤ects, liquidity dif-
ferences, and tax shields. Moreover, interest rate swap data are widely available at a
range of …xed maturities, which simpli…es the estimation process. Speci…cally, we obtain
daily observations of zero yields with maturities from 3 months to 30 years with equal
increment of 3 months. These zero yields are bootstrapped from the Libor/Swap term
structures, which consist of Libor rates with maturities of 3, 6 and 9 month and Swap
rates with maturities of 1, 2, 3, 4, 5, 7, 10, and 30 year. The sample period is from
January 4, 2005 to December 31, 2008. Figure 1 shows the dynamics of the default-free
zero yields, which allow us to compute the prices of zero coupon bonds with maturities
from 3 months to 30 years with an equal increment of 3 months.

4.2 Estimation of CDS Spreads

The CDS data used in our analysis are obtained from Markit. Based on quotes provided
by di¤erent dealers, Markit creates the daily composite quotes for each CDS contract.
It also provides average recovery rates used by data contributors in pricing each CDS

10
contract. Moreover, an average of Moody’s and S&P ratings is also provided. We focus
on US dollar denominated CDS contracts on all US non-sovereign entities. We only use
CDS on senior unsecured issues with modi…ed restructuring (MR) clauses, as they are
the most popular CDS contracts in the US market.
To obtain accurate estimates of model parameters and enough observations for out-
of-sample analysis, we require all …rms included in our study to have at least four years
of daily continuous observations of CDS spreads. Since the liquidity of CDS contracts
with a maturity di¤erent from 5 year might not be good during early years of the market,
we restrict our sample to the period between 2005 and 2008. In total, we have 297 …rms
in our …nal sample with continuous daily CDS spreads with maturities of 1, 2, 3, 5, 7,
10, 15, 20, and 30 years.
Table 1 provides summary statistics on the distribution of the 297 …rms in di¤erent
rating groups between 2005 and 2008. In results not reported, we see that the total
number of …rms in the dataset has increased dramatically from 309 in 2001 to 1,268 in
2009. During our sample period, the number of …rms are relatively stable. Among the 8
rating groups (from AAA to D), A, BBB, and BB rated …rms account for about 70-80%
of all the …rms with CDS trading. The table also contains the distribution of the …rms
among ten di¤erent industry groups, which include basic materials, consumer goods,
consumer services, …nancials, health care, industrials, oil & gas, technology, utilities,
and telecommunication. Financials have most …rms with CDS trading, followed by
consumer services, industrials, consumer goods, and utilities. Other industries have less
…rms with CDS trading.
Tables 2 and 3 provide the mean and standard deviation of CDS spreads for di¤erent
rating and industry groups. For most rating groups, we see an upward sloping credit
curve, which is consistent with the notion that on average default risk is higher over
longer maturity. For D-rated …rms, however, we see a downward sloping CDS curve.
This is consistent with the notion that for speculative grade bonds, the default risk can
be high in the near future but if the …rm survives long enough, then the default risk
actually goes down. The average credit curve for most industries also slopes upward.
One prominent exception is …nancial companies, whose CDS spread tends to decline
with maturity. In contrast, we …nd that the standard deviation of CDS spread generally
declines with maturity. In general, lower rated …rms have higher and more volatile

11
CDS spreads than higher rated …rms. One main exception is that the AAA-rated …rms
actually have higher spreads than some lower rated …rms. We believe this is mainly
because of the small number of AAA-rated …rms in our sample.
Based on the prices of default-free zero coupon bonds, we estimate the credit risk
model using the whole term structure of credit spreads for each of the 297 …rms. Table 4
presents the minium, maximum, median, mean, and interquartile range of the variance
ratios of CDS spreads at di¤erent maturities for the 297 …rms. Variance ratio measures
the percentage of variations of yields explained by the model. It is clear that the model
can explain the variations of most spreads very well. The average variance ratios for most
maturities and …rms are close to 90%. This suggests that our model does a reasonably
good job in capturing the term structure of CDS spreads.
Panel (a) of Table 5 reports the minium, maximum, median, mean, and interquartile
range of each estimated parameter based on the data during the whole sample period.
We …nd that the …rm-speci…c default intensity, ht , commands a negative risk premium,
since estimated Ps are signi…cantly bigger than
Z Z s. As we set 0 as a free parameter,
we can estimate the recovery rate for each individual …rm. And we …nd that the average
recovery rate exp ( 0) is around 50% and higher than the average quoted recovery rate,
which is around 40%.
Panel (a) of Table 6 presents the average estimates of Z
P Z across ratings and sectors.
Z
The quantity Z
P Z represents the mean of the default state variable Zt under the P
Z
measure. The results clearly show that the lower the rating, the higher the average
estimates of Z
P Z, which is consistent with the fact that default risks are higher for lower
Z
rated …rms. From this panel, we also see that the “Health Care” sector has the lowest
mean default rate under the P measure and that the “Basic Material” sector has the
highest mean default rate under the P measure. The ranking is di¤erent, however, during
the …rst sub-sample period due to probably di¤erent macroeconomic environments.
Panel (a) of Table 7 presents the average estimates of Z across ratings and sectors.
Z can be viewed as the mean of the default state variable Zt under the Q measure. The
mean of Zt is much higher under the Q measure than that under the P measure, again
con…rming that the default intensity, ht , commands a negative risk premium. In general,
the mean of Zt under the Q measure increases when the rating deteriorates. The only
exception is with the AAA rating category, which we suspect is due to the small number

12
of AAA-rated …rms in our sample. Finally, the “Oil & Gas” and “Industrial” are the
sector with the lowest and highest mean default rate under the Q measure, respectively.
Panel (a) of Table 8 presents the average estimates of the recovery rates exp ( 0)
across ratings and sectors. For ratings, the estimated recovery rates range from 40%
(CCC) to 55% (A). However, we do not …nd a monotone relation between recovery rate
and rating, maybe because the estimated “recovery rate”incorporates some counterparty
risks. The deviation of recovery rates across di¤erent sectors is smaller, ranging from
49% (Health Care) to 56% (Telecommunication), with an average of 51%.

4.3 Design and Performance of Statistical Arbitrage Strategies

4.3.1 Design and Implementation

Based on the estimated a¢ ne model for CDS spreads, in this section we develop trading
strategies to exploit potential statistical arbitrage opportunities in the term structure
of CDS spreads. Our basic approach is to construct market-neutral portfolios of CDS
contracts that are immune to both …rst and second order changes in the default state
variable. Then we would long (short) under (over) valued hedged portfolios. We brie‡y
describe the strategies here and refer readers to Section A for the details of the market-
neutral strategy and the computation of portfolio hedging weights.
We consider a second-order expansion of the CDS pricing function around the backed
out state variable Z^t with the following …rst and second order derivatives H (t) = 1
@St (Z) @ 2 St (Z)
@Z , and H2 (t) = @Z 2
; where is the maturity of the CDS contract.
^t
Z=Z ^t
Z=Z
We then can combine a CDS with maturity 0 with two other CDSs with maturities
1 and 2 to form a hedged portfolio. By choosing the appropriate weights of the CDS
contracts, we can hedge away ‡uctuations in the value of the portfolio due to changes
in Zt up to the second order. Speci…cally, we choose the weights of the other two CDS
contracts, m1 (t) and m2 (t) ; according to the following equations,

H2 0 (t) H1 2 (t) H1 0 (t) H2 2 (t) H2 0 (t) H1 1 (t) H1 0 (t) H2 1 (t)

m1 (t) = ; m2 (t) = :
H1 1 (t) H2 2 (t) H2 1 (t) H1 2 (t) H1 2 (t) H2 1 (t) H2 2 (t) H1 1 (t)

Consequently, the change in the value of the hedged portfolio should be both delta- and
gamma-neutral to changes in Zt . To achieve best hedging performance, in our setting,
we choose 1 and 2 as the two closest maturities to 0, e.g., if 0 = 1, then 1 = 2, and

13
 2 = 3; if 0 = 7, then 1 = 5, and 2 = 10; and if 0 = 30, then 1 = 15, and 2 = 20.
If our model is correctly speci…ed and all the CDS contracts are fairly priced, then
the excess return on the portfolio over the risk free rate should be close to zero. On the
other hand, if some of the CDS contracts are mis-valued, then we might be able to earn
positive excess returns. Given the estimated parameters, each week we re-estimate the
state variables to re…t the cross-sectional data as well as possible. Then based on the
estimated Z^t ; we construct the hedged portfolio at di¤erent maturities. We compare the
market and model price of the above hedged portfolio. If the market price is less than
model price, we would long the portfolio. But if the market price is higher than model
price, we would short the portfolio. We hold each investment for one week and then
liquidate the position.3 Since at each t; we only observe the refreshed CDS spreads, we
interpolate the CDS curve when we exit our position to approximate the payo¤ on our
portfolio.
For each company, we form arbitrage portfolios of CDS contracts at each maturity.
Then we decide which of the nine portfolios to long and short. Though each portfolio
should have zero market value when we initiate the position, we assume that we have
to put down one dollar, the notional amount of each CDS into each portfolio. Weekly
return of each portfolio is the sum of discounted (by default adjusted rate) future cash
‡ows generated by one week trading. So in total, we have nine portfolios, and the return
we earn in each …rm is the weighted average of returns of each individual portfolio.

4.3.2 Performance

In this section, we provide in-sample and out-of-sample analysis on the pro…tability of

our “arbitrage” strategy. In the in-sample analysis, we estimate model parameters and
construct trading portfolios using data that cover the entire sample period. In the out-
of-sample analysis, we divide our data into two parts, with the …rst part covering 2005
and 2006 and the second part covering 2007 and 2008. We estimate model parameters
using the …rst part of the data and implement the arbitrage strategy using the second
part of the data.
3
In results not reported here, we also hold the investment for two, three, and four weeks, but we
…nd that the one-week holding period has the best performance and the Sharpe ratios of the other three
holding periods are unimpressive. Our results suggest that the mis-pricing we identify disappears within
a week.

14
 We …rst look at the in-sample performance of our trading strategy. Panel (a) of
Table 9 presents the summary information of the in sample performance. In particular,
we report the minimum, median, mean, the …rst and third quartiles, and the maximum
of three important performance measures: the accumulative pro…t, the Sharpe Ratio,
and the maximum drawdown. And the average values of the three performance measures
across ratings and industry groups are presented in Panels (a) of Table 10, Table 11,
and Table 12. Accumulative pro…t is the net pro…t generated by the strategy, i.e., the
time-t accumulative pro…t is the sum of the pro…ts and losses realized up to time t. To
calculate Sharpe ratio, we convert the weekly return and standard deviation to annual
terms and subtract the (annualized) one-week Libor rate from the mean return. The
max drawdown measures the largest drop of the accumulative pro…t from the beginning
of the investment until now, and is formally de…ned as
( )n
max (AP (i))ji=1 AP (j)
max
max (AP (i))ji=1 + 9 j=1

where AP(i) stands for the accumulative pro…t at t = i.

We …nd that the in-sample accumulative pro…ts are all positive for the 297 …rms
and range from 0.34 to 14.76, with an average of 2.51. This means that in general
the strategy makes money. The CCC-rated …rms have the highest average accumulative
pro…ts of $6, the AAA-rated …rms have the lowest average accumulative pro…ts of $1, and
the average accumulative pro…ts are higher for lower-rated …rms. For di¤erent industry
sectors, “Consumer Service” and “Technology” have the highest average accumulative
pro…ts of $3, while Utility has the lowest accumulative pro…t of $1.7. Looking at the
intersections of ratings and sectors in Panel (a) of Table 10, we see that CCC-rated …rms
in the Basic Material sector have the highest average accumulative pro…ts of about $15,
while AAA-rated …rms in the Financials sector have the lowest accumulative pro…ts of
less than $1.
The excellent performance of the strategy is most evident by the Sharpe ratios it
produces. Panel (a) of Table 9 shows that the in-sample Sharpe ratios for the 297 …rms
range from -4.62 to 4.46 with an average of 2.09. Though a few …rms exhibit negative
Sharpe ratios, 75% of the …rms have Sharpe ratios higher than 1.6, 50% of the …rms
have Sharpe ratios higher than 2.16, and 25% of the …rms even have Sharpe ratios

15
higher than 2.6! Panel (a) of Table 11 shows that the strategy tends to produce higher
Sharpe ratios for lower rated …rms. For di¤erent industry sectors, “Consumer Services”
and “Industrial” have the highest average Sharpe ratios of about 2.40, while “Health
Care” and “Utility” have the lowest average Sharpe ratios of about 1.8. Moreover, we
see that CCC-rated …rms in the Industrial sector have the highest Sharpe ratio of 3.25,
while AAA-rated …rms in the Financials sector have the lowest Sharpe ratio of 0.3712.
In addition to the accumulative pro…t and Sharpe ratio, we also look at the max
drawdown to make sure that the strategy does not lead to dramatic decline in portfolio
value. Panel (a) of Table 9 shows that the in-sample max drawdowns of all …rms range
from 0.1% to 9%, with an average of 1.57%. This suggests that the average loss of the
strategy is very small compared to the initial investments. Panel (a) of Table 12 shows
that except for AAA- and AA-rated …rms, the average max drawndowns tend to be
higher for lower rated …rms. But the max drawdown of even the rating-sector group
with the highest drawdown is only 7%. The average max drawdowns for all industry
sectors range from 1.24% to 1.80%, which again are very small numbers.
While the above results show that our strategy performs very well in sample, it could
be due to over…tting of the data. To test the robustness of the trading performance, we
provide summary information on the out-of-sample performance of our trading strategy
in Panel (b) of Table 9. The most remarkable result is that, on average, the out-of-sample
performance of our strategy is almost as good as the in-sample one. For example, the
mean and median of out-of-sample Sharpe ratios for the 297 …rms is 1.88 and 2.06,
respectively, which are only slightly lower than that of in-sample Sharpe ratios. The
out-of-sample accumulative pro…ts are only slightly lower than the in-sample ones as
well. Though the highest out-of-sample max drawdown is almost twice of that of the
in-sample max drawdown, the mean and median of the out-of-sample max drawdown are
actually slightly lower than the in-sample ones. The out-of-sample average accumulative
pro…ts, Sharpe ratios, and max drawdowns for rating-industry sorted groups in Panels
(b) of Table 10, Table 12, and Table 11, respectively, are roughly consistent with the
in-sample results. Overall, the out-of-sample analysis shows that performance of our
trading strategy is robust and is unlikely due to over…tting of the data.
To further investigate how well the strategy applies to individual …rms, we present
summary statistics of P&L for 10 randomly selected …rms in Table 13. These 10 …rms

16
are “Cytec Inds Inc (Basic Material, BBB)”, “Procter & Gamble Co. (Consumer Good,
AA)”, “JetBlue Awys Corp. (Consumer Service, CCC)”, “Gen Elec Cap Corp. (Finan-
cials, AAA)”, “Boston Scienti…c Corp. (Health Care, BB)”, “Smur…t Stone Container
Enterp. (Industrials, B)”, “Marathon Oil Corp. (Oil & Gas,BBB)”, “Hewlett Packard
Co. (Technology, A)”, “BellSouth Corp. (Telecommunication, A)”, and “CMS Engy
Corp. (Utilities, BB)”. In the Table, for each …rm, we report the maximum, minimum,
mean, standard derivation, accumulative pro…t, Sharpe ratio, and max drawdown of the
in-sample and out-of-sample weekly returns.
We …nd that our strategy can generate very high Sharpe ratios for most of these 10
randomly selected …rms at one week holding period, either in sample or out of sample.
For example, for Smur…t Stone Cont., the accumulated pro…t is around $10 and the
Sharpe ratio is almost 3.0, either in sample or out of sample. And for CMS Engy Corp,
though the accumulative pro…t is lower, its in sample and out of sample Sharpe ratios
are almost 4.0! While for other …rms, the Sharpe ratios are lower, but they are still
much higher than that of a lot of other strategies. For example, the in-sample and
out-of-sample Sharpe ratios of JetBlue Awys Corp are about 2.4, and Cytec Inds Inc
has in-sample Sharpe ratio of 1.7 and out-of-sample Sharpe ratio of 1.4. For most …rms,
the di¤erences between the in-sample and out-of-sample performances of our strategy
are negligible. The only exception is Procter & Gamble Co whose Sharpe ratio drops
from 1.8 in sample to 0.6 out of sample. This con…rms the robustness of our strategy’s
performance. Furthermore, the small max drawdowns both in sample and out of sample
indicate that the performance of our strategy is very stable. Figures 2 and 3 provide
the in-sample time series plots of the accumulative pro…ts and the weekly returns of
the strategy with one week holding period. Figures 4 and 5 provide the out-of-sample
counterparts. We can see clearly the steady growth of the portfolio value in sample or out
of sample. Though the strategies su¤er losses some time, the exceptional out-of-sample
performance shows that on average we make money.
There are caveats that we need to keep in mind when looking at these high Sharpe
ratios. For example, we have not explicitly accounted for transactions costs and liquidity
concerns, which could eat into our pro…ts. Nonetheless, the impressive Sharpe ratios our
strategy generates do point out great potentials for “statistical” arbitrage in the term
structure of CDS spreads. There are many ways that we can improve our strategy. For

17
example, instead of trading all nine CDS, we can focus on the most extremely mis-valued
contracts, which might lead to higher pro…ts.

5 Conclusion

The rapid growth of the CDS market makes it possible to speculate on the relative
pricing of credit risk of a company across a wide range of maturities. Based on a
reduced-form model of credit risk, we explore “statistical” arbitrage opportunities in
the term structure of CDS spreads of a large number of companies in North America.
Speci…cally, we estimate an a¢ ne model for the term structure of CDS spreads of a
given company and identify mis-valued CDS contracts along the credit curve. We trade
market-neutral portfolios of mis-valued CDS contracts relative to our model, betting
that the mis-valuation will disappear over time. Empirical analysis shows that our
“arbitrage” strategy can be very pro…table. For most …rms, the Sharpe ratio are higher
than one, and for some …rms, the Sharpe ratio is even above two. The evidence we
document shows that there could be interesting “statistical” arbitrage opportunities in
the term structure of CDS spreads.

A Technical Details of Market Neutral Strategy

To understand mathematically the idea of our market neutral strategy, we …rst expand
the time t CDS pricing function of Z^T around the backed out state variable Z^t up to
second order as

1 2 3
St Z^T = St Z^t + H1 (t) Z^T Z^t + H2 (t) Z^T Z^t +O Z^T Z^t (6)
2

where

@St (Z)
H1 (t) =
@Z ^t
Z=Z
@2S t (Z)
H2 (t) = :
@Z 2 ^t
Z=Z

18
We assume for a short period of time t=T t, St Z^T can approximate ST t
Z^T
well, i.e.,
ST t
Z^T St Z^T :

Then, by the above approximation and ignoring high order terms, (6) can be rewritten
as
1 2
ST t
Z^T St Z^t + H1 (t) Z^T Z^t + H2 (t) Z^T Z^t :
2
Therefore, given a small t, at time t for 1 unit of CDS with maturity of 0, we could
employ other two CDSs with maturities of 1 and 2 to form a hedged portfolio, whose
values are immune to the variation of Zt up to second order, by setting the weights such
that

St 0 Z^t + m1 (t) St 1 Z^t + m2 (t) St 2 Z^t

t t t
ST 0 Z^T + m1 (t) ST 1 Z^T + m2 (t) ST 2 Z^T

therefore

H2 0 (t) H1 2 (t) H1 0 (t) H2 2 (t)

m1 (t) =
H1 1 (t) H2 2 (t) H2 1 (t) H1 2 (t)
H2 0 (t) H1 1 (t) H1 0 (t) H2 1 (t)
m2 (t) = :
H1 2 (t) H2 1 (t) H2 2 (t) H1 1 (t)

We can see that value of this portfolio is relatively stable over t.

If the model is “correct,” then the model value of the portfolio can be viewed as a
historical average of the market value of the portfolio,

CDSt 0 + m1 (t) CDSt 1 + m2 (t) CDSt 2

St 0 Z^t + m1 (t) St 1 Z^t + m2 (t) St 2 Z^t + t
0
+ m1 (t) t
1
+ m2 (t) t
2
;

where CDSt is the market value of the CDS spread4 with maturity of at time t, and
4
The reason we use value of CDS spread as a proxy of conventional value of CDS contract (value of
proctetion or premium leg of CDS contract) is that the value of proctetion or premium leg is contaminated
by interest rate risk, model price of market neutral portfolio of protection (premium) legs is not as stable
as that of CDS spreads. Therefore, it is more indicative to use CDS speads as trading indicator than
proctection (premium) legs. However, we might improve our strategy by using di¤erent m (t)s, which
take into account the risk of default intensity implicit in default adjusted rate, when constructing the

19
 t is the corresponding discrepancy between the market and model value. Therefore any
deviation from model value suggests the existence of arbitrage opportunities and that
we might be able to make pro…ts from either shorting or longing these portfolios.
actual trading porfolios.

20
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Longsta¤, F., S. Mithal, and E. Neis (2005). Corporate yield spreads: default risk or
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22
Table 1: Number of Firms in Di¤erent Rating and Industry Groups
This table provides the number of …rms used in our analysis in terms of rating and industry. The
ten industries are basic materials, consumer goods, consumer services, …nancials, health care,
industrials, oil & gas, technology, utilities, and telecommunication.

Rating Year AAA AA A BBB BB B CCC D

2005 2 10 68 119 48 43 8 0

# of …rm 2006 2 11 68 119 48 43 8 0

2007 2 12 72 127 62 52 8 0

2008 2 13 74 133 66 55 17 2

Sector BM CG CS Fin HC Ind OG Tec Tel Uti

# of …rm 27 48 55 44 13 37 24 14 9 26

23
Table 2: Summary Statisitics of CDS Spreads for Di¤erent Rating Groups
This table provides the mean and standard deviation of the CDS spreads in di¤erent rating
groups for all available maturities.

Rating 1y 2y 3y 5y 7y 10y 15y 20y 30y

AAA Mean 0.0156 0.0139 0.0136 0.0126 0.0117 0.0112 0.0113 0.0112 0.0113
Std. 0.0428 0.0349 0.0325 0.0275 0.0240 0.0213 0.0205 0.0199 0.0194

AA Mean 0.0061 0.0058 0.0059 0.0062 0.0063 0.0066 0.0069 0.0071 0.0072
Std. 0.0385 0.0306 0.0278 0.0238 0.0213 0.0190 0.0172 0.0178 0.0157

A Mean 0.0045 0.0048 0.0052 0.0059 0.0064 0.0070 0.0076 0.0079 0.0082
Std. 0.0191 0.0172 0.0161 0.0141 0.0127 0.0115 0.0111 0.0109 0.0108

BBB Mean 0.0059 0.0066 0.0074 0.0090 0.0098 0.0108 0.0115 0.0118 0.0120
Std. 0.0240 0.0203 0.0184 0.0160 0.0142 0.0128 0.0123 0.0121 0.0121

BB Mean 0.0132 0.0161 0.0187 0.0230 0.0243 0.0257 0.0266 0.0268 0.0268
Std. 0.0329 0.0326 0.0316 0.0309 0.0285 0.0269 0.0263 0.0256 0.0257

B Mean 0.0335 0.0406 0.0459 0.0527 0.0540 0.0548 0.0554 0.0555 0.0548
Std. 0.0723 0.0693 0.0663 0.0608 0.0567 0.0526 0.0516 0.0508 0.0493

CCC Mean 0.1273 0.1293 0.1303 0.1324 0.1314 0.1295 0.1269 0.1265 0.1216
Std. 0.2642 0.2325 0.2192 0.2023 0.1943 0.1867 0.1773 0.1772 0.1702

D Mean 0.6703 0.6179 0.6010 0.5944 0.5636 0.5322 0.4743 0.4784 0.4140
Std. 0.5959 0.3744 0.3500 0.3804 0.3752 0.3695 0.3009 0.2914 0.2672

24
Table 3: Summary Statisitics of CDS Spreads for Di¤erent Industry Sectors
This table provides the mean and standard deviation of CDS spreads for di¤erent industry
sectors for all available maturities.

Sector. 1y 2y 3y 5y 7y 10y 15y 20y 30y

BM Mean 0.0163 0.0181 0.0199 0.0229 0.0237 0.0246 0.0252 0.0254 0.0253
Std. 0.0873 0.0762 0.0741 0.0681 0.0630 0.0609 0.0579 0.0588 0.0555
CG Mean 0.0205 0.0226 0.0242 0.0267 0.0272 0.0277 0.0284 0.0284 0.0286
Std. 0.0742 0.0667 0.0619 0.0573 0.0532 0.0500 0.0489 0.0475 0.0465
CS Mean 0.0157 0.0198 0.0229 0.0268 0.0280 0.0290 0.0298 0.0300 0.0300
Std. 0.0528 0.0552 0.0563 0.0541 0.0524 0.0493 0.0480 0.0471 0.0467
Fin Mean 0.0158 0.0152 0.0150 0.0152 0.0149 0.0149 0.0151 0.0151 0.0153
Std. 0.0549 0.0467 0.0421 0.0375 0.0335 0.0307 0.0288 0.0280 0.0273
HC Mean 0.0044 0.0060 0.0076 0.0103 0.0114 0.0125 0.0132 0.0133 0.0135
Std. 0.0097 0.0123 0.0143 0.0170 0.0175 0.0178 0.0179 0.0177 0.0177
Ind Mean 0.0133 0.0144 0.0155 0.0178 0.0190 0.0199 0.0203 0.0208 0.0204
Std. 0.0632 0.0594 0.0565 0.0564 0.0574 0.0568 0.0546 0.0551 0.0522
OG Mean 0.0046 0.0060 0.0073 0.0099 0.0110 0.0122 0.0129 0.0131 0.0133
Std. 0.0090 0.0101 0.0110 0.0127 0.0128 0.0129 0.0132 0.0132 0.0128
Tec Mean 0.0122 0.0154 0.0179 0.0217 0.0231 0.0244 0.0252 0.0258 0.0255
Std. 0.0534 0.0513 0.0488 0.0457 0.0444 0.0424 0.0415 0.0411 0.0401
Tel Mean 0.0084 0.0116 0.0149 0.0191 0.0206 0.0220 0.0229 0.0233 0.0238
Std. 0.0168 0.0199 0.0232 0.0256 0.0250 0.0243 0.0242 0.0241 0.0240
Uti Mean 0.0048 0.0062 0.0077 0.0103 0.0114 0.0126 0.0133 0.0136 0.0139
Std. 0.0093 0.0100 0.0110 0.0123 0.0125 0.0125 0.0128 0.0128 0.0128

25
Table 4: Variance Ratio Summary

This table provides distribution of variance ratio, the percentage of variations of CDS spreads
explained by the credit risk model, of the 297 …rms used in our empirical analysis at 1, 2, 3, 5,
7, 10, 15, 20, and 30 year maturities

1y 2y 3y 5y 7y 10y 15y 20y 30y

Min -55% 17% 43% 60% 64% 44% 48% 37% 11%

1stQuantile 80% 87% 89% 89% 89% 85% 80% 78% 73%

Median 89% 93% 94% 94% 93% 91% 88% 87% 82%

Mean 81% 89% 91% 92% 91% 88% 85% 83% 79%

3rdQuantile 94% 96% 96% 95% 95% 94% 92% 92% 89%

Max 98% 99% 99% 99% 100% 100% 99% 98% 99%

26
Table 5: Estimation of CDS Spreads

This table reports the distribution of parameter estimates of the 297 …rms used in our empirical
analysis. Panel (a) is the summary of parameter estimates using full sample period (2005-2008),
Panel (b) is the summary of parameter estimates using …rst sub-sample period (2005-2006)

(a) Full Sample Summary

P exp(
Z Z Z Z 0) "

Min 0.0001 0.0080 0.0185 0.0084 0.3679 0.0005

1stQuantile 0.0022 0.4282 0.0455 0.3133 0.4461 0.0009

Median 0.0028 0.5432 0.0693 0.6534 0.5393 0.0017

Mean 0.0110 1.7572 0.1329 1.2472 0.5130 0.0056

3rdQuantile 0.0056 1.1189 0.1353 0.9507 0.5652 0.0037

Max 0.7371 123.6500 4.4288 11.3416 0.6873 0.0362

(b) First Sub-Sample Summary

P exp(
Z Z Z Z 0) "

Min 0.0001 0.0260 0.0188 0.0329 0.0000 0.0003

1stQuantile 0.0025 0.4839 0.0620 0.4576 0.1982 0.0006

Median 0.0038 0.9240 0.1046 1.2391 0.5665 0.0010

Mean 0.0077 2.3544 0.1127 1.9424 0.5241 0.0029

3rdQuantile 0.0075 1.9862 0.1493 2.3345 0.8267 0.0023

Max 0.2165 146.4283 0.4411 13.5166 0.9535 0.0280

27
Table 6: Average Estimated P
Z Z= Z across Ratings and Sectors

This table reports the average estimated ZP Z which is the mean of default state variable Zt
Z
under P measure. Panel (a) is the result from full sample period (2005-2008), Panel (b) is the
result from …rst sub-sample period (2005-2006)

(a) Full Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.0016 0.0109 0.0053 0.3933 0.0596 0.0864

CG 0.0006 0.0017 0.0385 0.0240 0.0055 0.0511 0.0218
CS 0.0008 0.0020 0.0071 0.0734 0.0414 0.0379 0.0291
Fin 0.0007 0.0016 0.0528 0.1319 0.0458 0.3867 0.0779
HC 0.0023 0.0017 0.0030 0.0022 0.0034 0.0024
Ind 0.0020 0.0052 0.0053 0.0036 0.0273 0.0044
OG 0.0015 0.0039 0.0124 0.0155 0.0059
Tec 0.0015 0.0178 0.0095 0.0539 0.0191
Tel 0.0077 0.0073 0.0071 0.0218 0.0089
Uti 0.0030 0.0033 0.0581 0.0601 0.0140
Aver. 0.0007 0.0014 0.0135 0.0265 0.0322 0.0727 0.1001 0.0314

(b) First Sub-Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.0030 0.0079 0.0180 0.0045 0.0221 0.0078

CG 0.0025 0.0285 0.0024 0.0385 0.0802 0.0076 0.0314
CS 0.0026 0.0063 0.0122 0.0243 0.0090 0.1946 0.0196
Fin 0.0032 0.0047 0.0081 0.0345 0.0074 0.0033 0.0165
HC 0.0080 0.0066 0.0107 0.0008 0.0051 0.0073
Ind 0.0118 0.0057 0.0058 0.1270 0.0254 0.0152
OG 0.0040 0.0060 0.0016 0.0042 0.0048
Tec 0.0050 0.0086 0.0045 0.0738 0.0207
Tel 0.0017 0.0021 0.0051 0.4307 0.0503
Uti 0.0130 0.0090 0.0256 0.0015 0.0100
Aver. 0.0032 0.0044 0.0094 0.0109 0.0201 0.0438 0.0746 0.0177

28
Table 7: Average Estimated Z across Ratings and Sectors

This table reports the average estimated Z which is the mean of default state variable Zt
under Q measure. Panel (a) is the result from full sample period (2005-2008), Panel (b) is the
result from …rst sub-sample period (2005-2006)

(a) Full Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.4459 1.6974 0.7279 3.0345 0.1881 1.4878

CG 0.2787 0.5091 0.9546 2.9236 3.7044 0.2700 1.9467
CS 0.2547 0.5095 1.4168 1.4786 1.4755 2.6547 1.3334
Fin 2.7434 0.2648 0.4625 2.0980 1.0438 2.7703 1.2192
HC 0.6557 0.3059 0.5290 0.3092 4.7409 1.0840
Ind 0.4698 0.7967 2.2839 2.2149 123.65 4.4052
OG 0.4565 0.6899 0.7714 3.3214 0.9804
Tec 0.6577 0.9006 3.6206 1.0110 1.4377
Tel 0.6291 1.8123 1.0393 5.6481 1.8038
Uti 0.5272 0.5996 2.1862 3.1114 1.0003
Aver. 2.7434 0.3056 0.4805 1.1501 1.9640 2.6728 22.0313 1.7572

(b) First Sub-Sample Result

AAA AA A BBB BB B CCC Aver.

BM 1.5619 0.8183 1.7551 2.1264 2.7668 1.4487

CG 0.2945 1.1902 0.5824 2.1501 5.6043 0.7684 2.0788
CS 1.6681 1.6955 1.8087 2.3714 5.2998 1.6160 2.7373
Fin 2.0219 0.8488 1.1492 11.0460 1.0663 0.4579 4.5765
HC 1.1106 1.3577 1.4630 0.3853 1.5924 1.3324
Ind 1.9051 1.6657 2.1625 5.6109 0.5541 2.0470
OG 0.7116 1.4033 0.7966 3.4444 1.4385
Tec 2.1909 1.1734 0.4998 5.2130 2.1854
Tel 0.5171 0.7780 1.0062 6.5438 1.4114
Uti 0.8739 0.8446 1.0931 6.4131 1.5108
Aver. 2.0219 0.8460 1.4002 2.4776 1.7712 4.7837 1.2966 2.3544

29
Table 8: Average Estimated Recovery Rates exp ( 0) across Ratings and Sectors

This table reports the average estimated recovery rates exp ( 0 ) which are assumed to be
constant over time. Panel (a) is the result from full sample period (2005-2008), Panel (b) is the
result from …rst sub-sample period (2005-2006)

(a) Full Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.5622 0.5377 0.4661 0.5392 0.4689 0.5325

CG 0.5398 0.5602 0.5311 0.5119 0.4210 0.3881 0.5052
CS 0.5831 0.5336 0.5017 0.4905 0.4921 0.3859 0.4991
Fin 0.4629 0.5155 0.5509 0.5246 0.5012 0.4197 0.5250
HC 0.5140 0.5232 0.5216 0.4009 0.3679 0.4887
Ind 0.5403 0.5267 0.4033 0.3935 0.3679 0.4989
OG 0.5571 0.5167 0.5172 0.4596 0.5180
Tec 0.5246 0.5615 0.4775 0.4639 0.5120
Tel 0.5684 0.5557 0.5749 0.5016 0.5568
Uti 0.5369 0.5141 0.5031 0.6185 0.5288
Aver. 0.4629 0.5270 0.5453 0.5230 0.4878 0.4764 0.4027 0.5130

(b) First Sub-Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.7563 0.5113 0.6399 0.1207 0.7212 0.5158

CG 0.6899 0.7737 0.3798 0.3353 0.3015 0.1077 0.4109
CS 0.9246 0.8096 0.6131 0.3374 0.2793 0.4109 0.5040
Fin 0.8416 0.6096 0.6864 0.5129 0.3601 0.4143 0.5857
HC 0.8482 0.8553 0.7620 0.4325 0.0013 0.6621
Ind 0.7022 0.5777 0.4766 0.4223 0.0535 0.5840
OG 0.6345 0.6160 0.3929 0.2045 0.5405
Tec 0.6816 0.5414 0.2552 0.5958 0.5318
Tel 0.6636 0.5009 0.0322 0.6086 0.4449
Uti 0.7384 0.5841 0.4702 0.0098 0.5328
Aver. 0.8416 0.6810 0.7289 0.5517 0.3682 0.2643 0.3531 0.5241

30
Table 9: Summary of Strategy Performance

This table reports Minimum, Median, Mean, 1st&3rd Quartiles, and Maximum of 3 important
performance measures: Accumulative Pro…t(Accum.), Sharpe Ratio, and Max
Drawdown(MDD). Panel(a) is the in sample result, Panel(b) is the out of sample result

(a) In Sample Result (b) Out of Sample Result

Accum. Sharpe MDD Accum. Sharpe MDD

Min 0.3429 -4.6183 0.09% Min 0.2516 -3.4593 0.10%

1stQ 1.4885 1.5768 0.84% 1stQ 1.1825 1.2944 0.61%

Median 2.0763 2.1575 1.16% Median 1.7791 2.0630 0.98%

Mean 2.5093 2.0890 1.57% Mean 2.2467 1.8793 1.45%

3rdQ 2.8655 2.6424 1.86% 3rdQ 2.7860 2.5670 1.55%

Max 14.7611 4.4609 8.99% Max 14.0332 4.3198 17.49%

31
Table 10: Average of Accumulative Pro…ts Across Rating and Sectors

This table reports average of accumulative pro…ts distribution across rating and sectors,
Panel(a) is the in sample result, Panel(b) is the out of sample result

(a) In Sample Result

AAA AA A BBB BB B CCC Aver.

BM 1.5009 1.7233 4.6531 2.8971 14.7611 2.7777

CG 1.6386 1.9535 2.0978 2.0882 5.0524 7.7142 2.7565
CS 0.9860 1.8132 2.4461 3.3465 4.0862 4.8683 2.9933
Fin 0.8950 2.2107 2.0378 2.4996 2.5342 2.3221 2.2227
HC 0.9449 1.4488 1.9696 2.1362 2.3618 1.7636
Ind 1.9689 2.4235 4.4776 5.7950 2.7210 2.8179
OG 1.8497 1.6589 2.0274 1.9919 1.7863
Tec 1.7230 2.2787 3.2227 5.1235 2.9318
Tel 2.0277 2.3961 3.0945 1.7483 2.3975
Uti 1.2296 1.6944 2.7375 1.8505 1.7212
Aver. 0.8950 1.8472 1.8177 2.1230 3.0098 3.8545 6.2092 2.5093

(b) Out of Sample Result

AAA AA A BBB BB B CCC Aver.

BM 1.1039 1.5688 3.5429 5.6203 4.8224 2.6345

CG 1.2007 1.4863 2.1653 2.1549 4.2058 6.0833 2.5163
CS 0.5916 1.1331 1.9001 3.6959 4.3283 2.6993 2.7422
Fin 0.7613 1.7794 1.6173 2.0930 4.0508 2.2903 2.0081
HC 0.8059 0.8500 1.2109 1.8140 2.6416 1.3074
Ind 1.4789 1.9827 3.1345 5.6116 2.5728 2.2176
OG 1.5218 1.2883 2.1015 2.3053 1.5657
Tec 1.3900 2.3063 3.4783 2.9043 2.4238
Tel 1.8209 2.2996 4.2478 1.2452 2.5090
Uti 0.9507 1.3588 2.9215 3.9449 1.7146
Aver. 0.7613 1.4475 1.3653 1.7992 3.0666 4.0838 3.5279 2.2467

32
Table 11: Average of Sharpe Ratios Across Rating and Sectors

This table reports average of Sharpe ratios distribution across rating and sectors, Panel(a) is
the in sample result, Panel(b) is the out of sample result

(a) In Sample Result

AAA AA A BBB BB B CCC Aver.

BM 1.6520 1.9278 2.1097 1.7564 2.6436 1.8778

CG 1.6442 1.9896 2.0634 1.8116 2.8300 3.1743 2.1385
CS 1.2891 2.0641 2.5359 2.7529 2.3001 2.1903 2.4175
Fin 0.3712 1.6742 1.5973 2.2787 2.0249 1.7130 1.8312
HC 0.9483 1.7021 1.9645 1.1250 2.3036 1.7730
Ind 1.8744 2.4576 3.0184 2.4483 3.2454 2.3844
OG 2.2582 1.7363 2.2625 1.7297 1.9100
Tec 1.3480 2.6522 2.2215 2.0189 2.0516
Tel 2.1223 2.1753 3.1749 1.6904 2.3318
Uti 1.1005 1.8008 3.2397 1.7120 1.7935
Aver. 0.3712 1.5571 1.7710 2.1561 2.3704 2.2373 2.5261 2.0890

(b) Out of Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.8930 1.7946 1.8387 2.1581 2.4812 1.6837

CG 1.0654 1.7556 2.1086 2.4238 2.5959 3.0154 2.2213
CS -0.374 1.1108 2.2688 2.6648 2.2363 2.3778 2.1252
Fin 0.1349 1.4143 1.4562 1.7454 2.4791 1.6167 1.5887
HC 0.6878 0.9602 1.2115 0.9592 2.6846 1.2818
Ind 1.4200 2.1564 3.0072 1.8399 2.9237 2.0504
OG 1.9905 1.3173 2.4263 1.9783 1.6788
Tec 0.9119 2.7571 2.2747 2.4254 2.0554
Tel 2.0577 2.0999 3.1950 1.2203 2.2362
Uti 0.0778 1.3819 3.5323 2.2080 1.4420
Aver. 0.1349 1.0931 1.2909 1.8654 2.5587 2.2764 2.4654 1.8793

33
Table 12: Average of Max Drawdown Across Rating and Sectors

This table reports average of Max Drawdown distribution across rating and sectors, Panel(a) is
the in sample result, Panel(b) is the out of sample result

(a) In Sample Result

AAA AA A BBB BB B CCC Aver.

BM 1.08% 1.52% 1.61% 2.21% 1.66% 1.57%

CG 1.10% 1.28% 1.45% 1.14% 2.49% 2.95% 1.56%
CS 0.43% 1.01% 1.34% 1.71% 2.31% 6.13% 1.76%
Fin 3.12% 2.08% 1.69% 1.71% 1.61% 1.14% 1.80%
HC 0.35% 1.15% 1.48% 4.42% 1.24% 1.46%
Ind 1.47% 1.18% 1.43% 0.89% 7.03% 1.45%
OG 0.83% 1.32% 0.96% 1.81% 1.24%
Tec 1.39% 0.87% 1.84% 3.32% 1.75%
Tel 0.87% 2.00% 1.12% 1.23% 1.47%
Uti 1.54% 1.03% 0.85% 2.56% 1.27%
Aver. 3.12% 1.55% 1.32% 1.36% 1.47% 2.24% 4.17% 1.57%

(b) Out of Sample Result

AAA AA A BBB BB B CCC Aver.

BM 0.82% 1.29% 1.01% 4.40% 1.11% 1.76%

CG 0.99% 1.15% 1.46% 1.17% 1.80% 2.65% 1.41%
CS 0.32% 0.70% 0.89% 2.68% 3.50% 5.05% 2.00%
Fin 0.80% 1.46% 1.37% 1.25% 2.28% 1.02% 1.39%
HC 0.24% 0.37% 0.67% 3.86% 1.60% 0.91%
Ind 1.22% 0.83% 1.05% 0.63% 7.92% 1.16%
OG 0.70% 0.98% 1.11% 2.55% 1.13%
Tec 0.86% 0.82% 2.21% 1.45% 1.26%
Tel 0.47% 1.81% 1.61% 1.50% 1.43%
Uti 0.91% 0.74% 0.84% 4.39% 1.19%
Aver. 0.80% 1.13% 0.98% 1.05% 1.70% 2.80% 3.80% 1.45%

34
Table 13: The P&L of the Statistical Arbitrage Strategy for 10 Firms

This table provides summary statistics of P&L for the statistical arbitrage strategies for ten
individual …rms, which include the max, min, mean, standard deviation, accumulated pro…t,
Sharpe ratio, and Max Drawdown. Panel(a) is the in sample result, Panel(b) is the out of
sample result

(a) In Sample Result

Sector Rating Max Min Aver. Std. Accum. Sharpe MDD

Cytec Inds Inc BM BBB 0.08 -0.04 0.01 0.02 1.20 1.68 0.5%
Procter & Gamble Co CG AA 0.20 -0.08 0.02 0.05 1.75 1.78 0.8%
JetBlue Awys Corp CS CCC 0.85 -0.49 0.07 0.19 6.69 2.35 3.3%
Gen Elec Cap Corp Fin AAA 0.19 -0.20 0.01 0.04 0.96 0.50 2.3%
Boston Scienti…c Corp HC BB 0.51 -0.38 0.02 0.09 2.14 1.12 4.4%
Smur…t Stone Cont. Ind B 1.45 -0.06 0.10 0.24 9.61 2.78 0.7%
Marathon Oil Corp OG BBB 0.08 -0.04 0.01 0.02 1.24 1.70 0.5%
Hewlett Packard Co Tec A 0.11 -0.06 0.01 0.03 1.25 1.38 0.7%
BellSouth Corp Tel A 0.38 -0.07 0.02 0.05 2.08 2.13 1.0%
CMS Engy Corp Uti BB 0.14 -0.06 0.03 0.04 2.64 3.63 0.6%

(b) Out of Sample Result

Sector Rating Max Min Aver. Std. Accum. Sharpe MDD

Cytec Inds Inc BM BBB 0.07 -0.04 0.01 0.02 1.05 1.43 0.4%
Procter & Gamble Co CG AA 0.07 -0.04 0.01 0.02 0.83 0.64 0.4%
JetBlue Awys Corp CS CCC 0.26 -0.11 0.02 0.05 2.37 2.40 1.1%
Gen Elec Cap Corp Fin AAA 0.17 -0.12 0.01 0.03 0.95 0.63 1.3%
Boston Scienti…c Corp HC BB 0.46 -0.36 0.02 0.08 1.81 0.96 3.9%
Smur…t Stone Cont. Ind B 1.46 -0.07 0.11 0.27 10.29 2.67 0.8%
Marathon Oil Corp OG BBB 0.07 -0.03 0.01 0.02 1.06 1.37 0.4%
Hewlett Packard Co Tec A 0.05 -0.03 0.01 0.02 0.88 1.03 0.3%
BellSouth Corp Tel A 0.24 -0.03 0.02 0.03 1.42 1.81 0.3%
CMS Engy Corp Uti BB 0.16 -0.06 0.03 0.05 3.04 3.87 0.7%

35
Figure 1: Dynamics of Zero Yields

This …gure provides dynamics of zero yields bootstrapped from LIBOR and Swap rates
with maturities from 3 months to 30 years with equal increment of 3 months. Sample period
spans the begining of 2000 and the end of 2008.

0.06

0.05
Zero Yields

0.04

0.03

0.02

30
25
20
08
15
10 07
5 06

M aturities Date

36
Figure 2: In Sample Paths of Accumulative Pro…ts for 10 …rms

This …gure provides the in sample paths of accumulated pro…ts of the statistical arbi-
trage strategy for 10 …rms between January 17, 2007 and December 31, 2008.

Cytec Inds Inc(BM ,BBB) Procter & Gam bl e Co(CG,AA)

1
1
0.5
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

JetBl ue Awys Corp(CS,CCC) Gen Elec Cap Corp(Fin,AAA)

5 0.8
0.6
0.4
0.2
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Boston Scienti fic Corp(HC,BB) Sm urfi t Stone Contai ner Enterp(Ind,B)

2
1 5

0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

M arathon Oi l Corp(OG,BBB) Hewl ett Packard Co(T ec,A)

1 1
0.5 0.5
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Bell South Corp(T el,A) CM S Engy Corp(Uti,BB)

2
2
1 1
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

37
Figure 3: In Sample Time Series of P&L for 10 …rms.

This …gure provides the in sample time series of the P&L of the statistical arbitrage
strategy for 10 …rms between January 17, 2007 and December 31, 2008.

Cytec Inds Inc(BM ,BBB) Procter & Gam bl e Co(CG,AA)

0.08 0.2
0.06
0.04 0.1
0.02
0 0
-0.02
-0.04
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

JetBl ue Awys Corp(CS,CCC) Gen Elec Cap Corp(Fin,AAA)

0.8
0.6 0.1
0.4
0.2 0
0 -0.1
-0.2
-0.4 -0.2
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Boston Scienti fic Corp(HC,BB) Sm urfi t Stone Contai ner Enterp(Ind,B)

0.4
0.2 1
0 0.5
-0.2
0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

M arathon Oi l Corp(OG,BBB) Hewl ett Packard Co(T ec,A)

0.1
0.06
0.04 0.05
0.02
0 0
-0.02 -0.05
-0.04
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Bell South Corp(T el,A) CM S Engy Corp(Uti,BB)

0.3 0.1
0.2 0.05
0.1 0
0 -0.05
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

38
Figure 4: Out of Sample Paths of Accumulative Pro…ts for 10 …rms

This …gure provides the out of sample paths of accumulated pro…ts of the statistical
arbitrage strategy for 10 …rms between January 17, 2007 and December 31, 2008.

Cytec Inds Inc(BM ,BBB) Procter & Gam bl e Co(CG,AA)

1
0.5
0.5

0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

JetBl ue Awys Corp(CS,CCC) Gen Elec Cap Corp(Fin,AAA)

2 0.8
0.6
1 0.4
0.2
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Boston Scienti fic Corp(HC,BB) Sm urfi t Stone Contai ner Enterp(Ind,B)

10
1 5

0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

M arathon Oi l Corp(OG,BBB) Hewlett Packard Co(T ec,A)

1 0.8
0.6
0.5 0.4
0.2
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Bell South Corp(T el,A) CM S Engy Corp(Uti,BB)

1 2
0.5
0 0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

39
Figure 5: Out of Sample Time Series of P&L for 10 …rms.

This …gure provides the out of sample time series of the P&L of the statistical arbitrage
strategy for 10 …rms between January 17, 2007 and December 31, 2008.

Cytec Inds Inc(BM ,BBB) Procter & Gam bl e Co(CG,AA)

0.06 0.06
0.04 0.04
0.02 0.02
0 0
-0.02 -0.02
-0.04
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

JetBl ue Awys Corp(CS,CCC) Gen Elec Cap Corp(Fin,AAA)

0.2 0.1
0.1
0
0
-0.1 -0.1
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Boston Scienti fic Corp(HC,BB) Sm urfi t Stone Contai ner Enterp(Ind,B)

0.4
0.2 1
0 0.5
-0.2
0
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

M arathon Oi l Corp(OG,BBB) Hewlett Packard Co(T ec,A)

0.06 0.04
0.04
0.02 0.02
0 0
-0.02 -0.02
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

Bell South Corp(T el,A) CM S Engy Corp(Uti,BB)

0.2 0.15
0.1
0.1 0.05
0
0 -0.05
Jan07 Jan08 Jan09 Jan07 Jan08 Jan09

40