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 independently 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 and 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.
- capital structure arbitrage
- credit default swaps
- portfolio management
- large-scale covariance estimation
- portfolio optimisation
Calice, G., Chen, J., & Williams, J. M. (2013). Are there benefits to being naked? The returns and diversification impact of capital structure arbitrage. European Journal of Finance, 19(9), 815-840. https://doi.org/10.1080/1351847X.2011.637115