Convertible Arbitrage is an investment strategy employed primarily by hedge funds, involving the purchase of convertible securities and the simultaneous short-selling of the underlying common stock. This method aims to capitalize on the pricing inefficiencies between the convertible security and the underlying stock.
How Convertible Arbitrage Works
Convertible Securities
Convertible securities are financial instruments, typically bonds or preferred shares, that can be converted into a predetermined number of common shares of the issuing company. These securities offer fixed income characteristics through interest or dividends while providing the potential for equity-like returns upon conversion.
Short-Selling the Underlying Stock
In conjunction with purchasing convertible securities, investors short-sell the underlying stock. Short-selling involves borrowing shares and selling them at the current market price, with the intention of buying them back at a lower price in the future. This position aims to hedge against the equity risk associated with the convertible security.
Arbitrage Mechanism
The primary goal is to exploit the mispricing between the convertible security and the underlying stock. By balancing the long position in the convertible bond and the short position in the equity, the investor seeks to create a risk-neutral position that can generate profit from the price convergence.
Types of Convertible Arbitrage
Delta Neutral Strategy
Delta neutral strategies involve maintaining a balance where the portfolio’s value is not significantly affected by small changes in the price of the underlying stock. This is achieved by adjusting the ratio of long convertible bonds to short stock as the stock price fluctuates.
Gamma Neutral Strategy
This approach involves creating a hedge that remains neutral to the convexity or curvature (gamma) of the underlying stock’s price changes. This methodology focuses on the higher-order sensitivities of options pricing.
Special Considerations
Volatility and Market Conditions
The effectiveness of convertible arbitrage greatly depends on market volatility and liquidity. High volatility can enhance the profitability of the strategy, while low liquidity can pose challenges in executing trades efficiently.
Credit Risk
Investors are exposed to the credit risk of the issuer of the convertible securities. Deterioration in the issuer’s creditworthiness can adversely affect the value of the convertible bonds.
Examples of Convertible Arbitrage
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Example 1: An investor purchases a convertible bond with a par value of $1,000, convertible into 50 shares of the company’s stock. Simultaneously, the investor shorts 50 shares of the underlying stock. If the stock price falls, the short position gains value, offsetting potential losses on the convertible bond.
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Example 2: An investor buys a convertible bond of Company XYZ and shorts the company’s shares. Over time, as the convertible bond’s value remains stable and the stock price fluctuates, gains are realized through the difference in pricing movements.
Historical Context
Convertible arbitrage gained prominence in the 1980s and 1990s with the rise of hedge funds specialized in exploiting fixed-income and equity market inefficiencies. Regulatory changes and market evolution have influenced strategies and their profitability over time.
Applicability
Convertible arbitrage strategies are essential for institutional investors and hedge funds seeking to generate returns from arbitrage opportunities while managing risk exposure. These strategies are less common among retail investors due to complexity and capital requirements.
Comparisons
- Convertible Arbitrage vs. Traditional Arbitrage: Traditional arbitrage involves exploiting price differences in the same asset across different markets, whereas convertible arbitrage focuses on the pricing inefficiency between a convertible security and its underlying stock.
Related Terms
- Hedge Funds: Investment funds that employ diverse strategies, including convertible arbitrage, to achieve high returns.
- Convertible Bond: A type of bond that can be converted into a predetermined number of company shares.
- Short Selling: The sale of a borrowed security with the expectation of buying it back at a lower price.
FAQs
What is the main goal of convertible arbitrage?
Is convertible arbitrage risky?
When is convertible arbitrage most effective?
References
- McMillan, L. G. (2004). Options as a Strategic Investment. New York: New York Institute of Finance.
- Choudhry, M. (2010). Bond and Money Markets: Strategy, Trading, Analysis. London: Butterworth-Heinemann.
- Hull, J. C. (2012). Options, Futures, and Other Derivatives. Prentice Hall.
Summary
Convertible arbitrage is an advanced investment strategy aimed at capitalizing on the price discrepancies between convertible securities and their underlying stocks. By balancing long positions in convertibles with short sales of the associated stocks, investors seek to create a market-neutral portfolio that profits from price convergence, while managing the risks associated with market volatility and issuers’ creditworthiness.
