Convertible arbitrage is a
market-neutral investment strategy In finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio. Individuals have different profit objectives, and their individual skills make different tactics ...
often employed by
hedge fund
A hedge fund is a pooled investment fund that trades in relatively liquid assets and is able to make extensive use of more complex trading, portfolio-construction, and risk management techniques in an attempt to improve performance, such as ...
s. It involves the simultaneous purchase of
convertible securities and the
short sale of the same issuer's
common stock
Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Com ...
.
The premise of the strategy is that the convertible is sometimes priced inefficiently relative to the underlying stock, for reasons that range from
illiquidity
In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
to
market psychology. In particular, the equity option
embedded in the convertible bond may be a source of cheap
volatility, which convertible
arbitrageurs can then exploit.
The number of shares sold short usually reflects a
delta-neutral or market-neutral ratio. As a result, under normal market conditions, the arbitrageur expects the combined position to be insensitive to small fluctuations in the price of the underlying stock. However, maintaining a market-neutral position may require rebalancing transactions, a process called dynamic
delta hedging In finance, delta neutral describes a portfolio of related financial securities, in which the portfolio value remains unchanged when small changes occur in the value of the underlying security. Such a portfolio typically contains options and their ...
. This rebalancing adds to the return of convertible arbitrage strategies.
Risks
As with most successful
arbitrage
In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between t ...
strategies, convertible arbitrage has attracted a large number of market participants, creating intense competition and reducing the effectiveness of the strategy. For example, many convertible arbitrageurs suffered losses in early 2005 when the credit of
General Motors was downgraded at the same time
Kirk Kerkorian was making an offer for GM's stock. Since most arbitrageurs were long GM debt and short the equity, they were hurt on both sides. Going back a lot further, many such "arbs" sustained big losses in the so-called
"crash of '87". In theory, when a stock declines, the associated convertible bond will decline less, because it is protected by its value as a fixed-income instrument: it pays interest periodically. In the
1987 stock market crash, however, many convertible bonds declined more than the stocks into which they were convertible, apparently for liquidity reasons, with the market for the stocks being much more liquid than the relatively small market for the bonds. Arbitrageurs who relied on the traditional relationship between stock and bond gained less from their short stock positions than they lost on their long bond positions.
Controversy
In the past, most people in the market believed that convertible bond arbitrage was mainly due to convertible underpricing.
However, recent studies find empirical evidence that convertible bonds usually generate relatively large positive gammas that can make delta-neutral portfolios highly profitable. Other research suggests that arbitrageurs in general take advantage of illiquidity and higher volatility.
See also
*
Convertible bond
In finance, a convertible bond or convertible note or convertible debt (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond that the holder can convert into a specified number of shares of common stock ...
*
Convertible security
References
Further reading
Xiao, Tim (2013)
"A simple and precise method for pricing convertible bond with credit risk" Journal of Derivatives & Hedge Funds, 19 (4), 259–277.
External links
{{DEFAULTSORT:Convertible Arbitrage
Arbitrage
Financial markets