In early November credit protection on building materials group Hanson was trading at 95bp while some traders' debt equity models said the correct valuation was 160bp. Its shares held steady. That was the trigger that capital structure arbitrageurs were waiting for.
The most likely outcome, they thought, was that spreads would widen back to previous levels or go even higher. To take advantage of that, some went long credit default swaps - or short the underlying bond - and bought equity as a hedge.
One trader who talked to Euromoney bought e10 million-worth of Hanson's five-year credit default swaps over the course of November 5 and 6 when they were at 95bp. At the same time, using an equity delta of 12% derived from a proprietary debt equity model, he bought ?1.2 million-worth of stock at £2.91