Convertible Bond Arbitrage involves taking a long position in a convertible bond and a short position in the underlying common stock. A convertible security is one that can be converted into another form, such as a convertible preferred stock, which can be changed from a Convertible Preference share to an Equity share/Common stock. "A simple and precise method for pricing convertible bond with credit risk", Journal of Derivatives & Hedge Funds, 19 (4), 259-277. 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. The arbitrage manager decides to make initial cash investment of $202,500 + $877,500 of borrowed funds = Total investment of $1,080,000. Convertible bond arbitrage This trading strategy aims to monetise the optionality premium in convertible bonds versus the equity from the same issuer. The deciding factor for the success of such a strategy is the manager risk rather than directional equity or bond market risk. Today he will continue to explain how convertible bond arbitrage works along with some case studies. In 2005, investor redemptions had a significant impact on the strategy’s returns, although the maximum drawdown remains significantly less as compared to traditional equity and bond markets. This increasingly popular strategy, which is especially useful during times of market volatility, allows individuals to increase their returns while decreasing their risks. Advent’s Balanced Convertibles Strategies capture the essence of convertible investing by focusing on opportunities in the “balanced” part of the market (convertibles trading within the 50%-85% delta range) where we believe we can capture the upside potential of the equity market with only a portion of the risk. It is a long-short trading strategy favored by hedge funds and large-scale traders. Also, look at Accounting for convertible bonds. A convertible bond arbitrage strategy is one that benefits from the difference in pricing between a convertible bond and the stock price. The Fund seeks to achieve positive absolute returns over the long-term with low volatility when compared to traditional market indices. If the stock is trading at par and not going either up or down, the convertible security or the debenture will continue to pay a steady coupon rate, which shall offset the costs of holding the short stock. A typical convertible bond arbitrage employs delta-neutral hedging, in which an arbitrageur buys a convertible bond and sells the underlying equity at the current delta (see Choi et al (2009), Loncarski et al (2009), etc.). Event-driven investments include a suite of other arbitrage strategies typically occurring around corporate actions and events. Arbitrageurs can fall victim to unpredictable events with no limits to the downside effects. This rebalancing adds to the return of convertible arbitrage strategies. However, maintaining a market-neutral position may require rebalancing transactions, a process called dynamic delta hedging. It is essential to continuously monitor the markets and take advantage of situations whereby the bond/stock is undervalued. 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. Convertible arbitrage is a strategy that involves taking a long position in a convertible security and a short position in an underlying common stock. Arbitrage – Convertible Bond… Convertible arbitrage is a type of equity long-short investing strategy often used by hedge funds. Convexity is the right asset for your portfolio. The short stock position “hedges” the long stock position that is obtained via the convertible portion of the bond. Another idea behind adopting a convertible arbitrage is that a firm’s convertible bonds are priced inefficiently relatively to its stock. The strategy covers the following areas: convertible bond arbitrage, tail protection, volatility or opportunistic trades in this area, including but not limited to other areas such as capital structure arbitrage, ETF arbitrage or arbitrage of other closely related instruments. …uh, okay maybe fun is the wrong word. The strategy still appears to be a good portfolio hedge in situations of volatility. Dollars) Convertible arbitrage market (millions of U.S. $) % Change in asset flows other arbitrage practices that tend to gain more investor attention during sideways or declining markets. • Convertible bond buyers hope to earn a liquidity premium for holding an illiquid asset and providing Copyright © 2020. Going back a lot further, many such "arbs" sustained big losses in the so-called "crash of '87". It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock. Prior to joining Lazard in 2007, Sean was a portfolio manager for convertible arbitrage strategies at SAC Capital Management from April 2003 to August 2006 and, subsequent to this, senior portfolio manager at Sailfish Capital Partners' G2 Multistrategy Fund. iShares Convertible Bond ETF provides investors risk exposure to a lesser-known part of the hybrid fixed income market – that of convertible bonds. Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. However, successful convertible bond strategies require precise hedging to ensure other directional risk factors do not adversely impact the strategy. If the investor decides to hedge $5,000 worth of the equity with a currency position, the hedge ratio is 0.5 (50/100). The rationale for adopting a convertible arbitrage strategy is that the long-short position enhances the possibility of gains is made with a relatively lower degree of risk. Xiao, Tim (2013). Many investors may be unfamiliar with this type of bond, but it is quite simple. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. The CB01 risk metric can be used to ensure convertible arbitrage strategies use the most effective hedges either by adding credit instruments or, more efficiently, by using pure equity. Convertible Bond Arbitrage Definition - Investopedia Convertible Arbitrage refers to the trading strategy used in order to capitalize on the pricing inefficiencies present between the stock and the The number of shares sold short usually reflects a delta-neutral or market-neutral ratio. 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. One instance was during 2005, when many arbitrageurs held long positions in General Motors (GM) convertible bonds and short positions in GM stock. Convertible arbitrage starts with the purchase of a convertible bond. 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. Convertible Arbitrage is trickier than it sounds. As with most successful arbitrage strategies, convertible arbitrage has attracted a large number of market participants, creating intense competition and reducing the effectiveness of the strategy. Convertible Arbitrage Market Value (Millions of U.S. This involves going long the Convertible Bond and shorting the underlying stock according to the calculated delta-hedge. 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