million minus recovery (either by physical or cash settlement — see Settlement below). The pension fund still loses the $600,000 it has paid over three years, but without the CDS contract it would have lost the entire $10 million minus recovery. In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables. Although credit default swaps have been highly criticized for their role in the recent financial crisis, most observers conclude that using credit default swaps as a hedging device has a useful purpose. Arbitrage Capital Structure Arbitrage is an example of an arbitrage strategy that uses CDS transactions. This technique relies on the fact that a company's stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However, if its outlook worsens then its CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company's capital structure; i.e., mis-pricings between a company's debt and equity. An arbitrageur attempts to exploit the spread between a company's CDS and its equity in certain situations. For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore, a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company's CDS spread tightened relative to its equity. An interesting situation in which the inverse correlation between a company's stock price and CDS spread breaks down is during a Leveraged buyout (LBO). Frequently this leads to the company's CDS spread widening due to the extra debt that will soon be put on the company's books, but also an increase in its share price, since buyers of a company usually end up paying