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convertible bond arbitrage strategy

It is essential to continuously monitor the markets and take advantage of situations whereby the bond/stock is undervalued. In August 2017, The Absolute Convertible Arbitrage Fund was converted from a hedge fund managed by Mohican Financial Management (which was launched in 2002). Previously he was a convertible arbitrage portfolio manager at the Clinton Group, Inc. The convertible arbitrage strategy has produced attractive returns over the past two decades, which are not correlated with the individual performance of the bond or the equity market. This increasingly popular strategy, which is especially useful during times of market volatility, allows individuals to increase their returns while decreasing their risks. Purchased at a price of 108 and assuming sold at a price of 120 per $1,000, Sold equity stock at $26.625 and stock rose to $31.00 [i.e. 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. A convertible bond arbitrage strategy is one that benefits from the difference in pricing between a convertible bond and the stock price. It involves the simultaneous purchase of convertible securities and … Xiao, Tim (2013). "A simple and precise method for pricing convertible bond with credit risk", Hedge Fund Strategy - Convertible Arbitrage, Taxation of private equity and hedge funds, Alternative investment management companies, https://en.wikipedia.org/w/index.php?title=Convertible_arbitrage&oldid=960725705, Creative Commons Attribution-ShareAlike License, This page was last edited on 4 June 2020, at 15:32. Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds. Expertise. A typical investment is to be long the convertible bond and short the common stock of the same company. Marc joined UBP in 2018 from AXA IM where he headed the global and European convertible bond strategies team for over fifteen years, after his previous role as convertible arbitrage strategy fund manager at BFT. Before launching his relative value/convertible bond arbitrage fund in partnership with Trium Capital in 2017, Dobbs managed similar strategies for well-known hedge fund firms including CQS, Sir Michael Hintze’s multi-strategy credit-focused outfit, BlueCrest Capital Management, the long-running New York-based manager founded by Michael Platt and William Reeves, and Tribeca Global … Also, look at Accounting for convertible bonds. A billionaire investor attempted to make a bulk purchase of their stocks, causing strategies of fund managers to a tailspin. Convertible arbitrage is a type of equity long-short investing strategy often used by hedge funds. Convertible Arbitrage faces the following risks –. The arbitrage manager decides to make initial cash investment of $202,500 + $877,500 of borrowed funds = Total investment of $1,080,000. Arbitrageurs can fall victim to unpredictable events with no limits to the downside effects. Convertible Bond Arbitrage Arbitrageurs can exploit the discount on convertible bonds while limiting exposure to unwanted risks, through the strategy of longing the convertible bond and shorting the underlying assets. This is similar to being long a call option on the stock. The expectation was that the present value of GM stocks would fall, but the debt will continue to earn revenues. 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. The Fund seeks to achieve positive absolute returns over the long-term with low volatility when compared to traditional market indices. To achieve this, Mohican, the sub-adviser to the Fund, expects to […] Additionally, high leverage is also a potential risk factor since it can reduce the returns earned. This culminates that 50% of the equity position is prevented from exchange rate risks. In the past, most people in the market believed that convertible bond arbitrage was mainly due to convertible underpricing. Convertible arbitrage strategies typically involve buying a convertible bond and simultaneously selling short equity of the same company. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. E.g., if one is holding $10,000 in foreign equity, this does expose the investor to FOREX risk. Convexity is the right asset for your portfolio. Convertible arbitrage involves purchasing a portfolio of convertible securities-generally convertible bonds-and hedging a portion of the equity risk by selling short the underlying common stock. While convertible bonds remain a niche asset class, the revival in new issuance and an apparent bottoming in volatility expectations as monetary policy has become less predictable, both bode well for convertible arbitrage strategies. Let’s take a practical example of how a convertible arbitrage will work: The initial price of a convertible bond is $108. 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 is a market-neutral investment strategy often employed by hedge funds. The share price is at 26.625 per share, and the manager shorts 26,000 shares costing $692,250. However, the debt began to be downgraded by the credit rating agencies. It’s similar in most respects to a traditional bond—it is legally bound to fulfill its interest payments and repay its principal, unlike a … A convertible bond arbitrage strategy can exhibit unique return characteristics as a result of how the price of a convertible bond is influenced by credit dynamics and the issuer’s equity price. Copyright © 2020. Since most arbitrageurs were long GM debt and short the equity, they were hurt on both sides. Today he will continue to explain how convertible bond arbitrage works along with some case studies. With delta Convertible Bond Arbitrage involves taking a long position in a convertible bond and a short position in the underlying common stock. Now, convertible arbitrage is a trading strategy that aims to exploit the price difference between a convertible bond issued by a company and its underlying equity shares. Let’s quickly define Arbitrage: Arbitrage Arbitrage is when you are long and short two related securities (or … The strategy is successful because as the equity declines, the convertible bond begins to 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. The debt to equity ratio, in this case, will be 4.33:1 (Debt being 4.33 times of the equity investment amount). The Portfolio is a pure global convertible bond portfolio managed through an active bond picking approach based on fundamental and technical analysis of convertible bonds. Contribution from Leverage is very significant. 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.). The deciding factor for the success of such a strategy is the manager risk rather than directional equity or bond market risk. Loss of $4.375*26,000 shares], Interest of $50,000 earned/bond price of $1,080,000*100 = 4.6%, Interest of $8,653 earned/bond price of $1,080,000*100 = 0.8%, Dividends of $6,922 paid/bond price of $1,080,000*100 = -0.6%, Interest of $17,550 paid/bond price of $1,080,000*100 = -1.6%, Return of $6,250 earned/bond price of $1,080,000*100 = 0.6%. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock. On the other hand, the convertible bond or Debentures will have limited risks since it is an instrument having a fixed rate of income. …uh, okay maybe fun is the wrong word. Convertible bond arbitrage is a strategy executed mostly by hedge funds. For example, during the corporate-scandal-Convertible Arbitrage: An … Convertible Arbitrage refers to the trading strategy used in order to capitalize on the pricing inefficiencies present between the stock and the convertible where the person using the strategy will take the long position in the convertible security and the short position in underlying common stock. Convertible Arbitrage Market Value (Millions of U.S. Convertible bond portfolios are designed to offer some of the capital-appreciation potential of stock portfolios while also supplying some of the safety and yield of bond portfolios. To hedge the equity portion, we can short stock as the price rises, or cover additional stock if the price falls. For instance, if a fund has acquired a convertible instrument of ABC Co. with a lock-in period of 1 year. Convertible Arbitrage is trickier than it sounds. The premise of the strategy is that the convertible is sometimes priced inefficiently relative to the underlying stock, for reasons that range from illiquidity to market psychology. 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. 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. Other research suggests that arbitrageurs in general take advantage of illiquidity and higher volatility. The strategy still appears to be a good portfolio hedge in situations of volatility. In particular, the equity option embedded in the convertible bond may be a source of cheap volatility, which convertible arbitrageurs can then exploit. 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. Convertible arbitrage is a trading strategy that typically involves taking a long position (buy) in a convertible security and a short position (sell) in the underlying common stock. If the value of the stock declines, the arbitrage trader will benefit from the short position in stock since it is equity and matter flows in the direction of the market. The returns from the bond are going to be fixed, which keeps the manager in a relatively safer position but is required to predict the market volatility also for maximizing their returns and extract maximum benefit from simultaneous hold and sell strategies. What is Hedge Ratio in Convertible Arbitrage? Another idea behind adopting a convertible arbitrage is that a firm’s convertible bonds are priced inefficiently relatively to its stock. Many investors may be unfamiliar with this type of bond, but it is quite simple. Previously he was a convertible arbitrage the intuition behind convertible bond arbitrage strategy strategy is one that from! Rate risks higher volatility convertible securities and the short stock as the price falls volatility when compared to the of... Gm stocks would fall, but the debt will continue to earn revenues arbs '' sustained big in! Like the shares of the company stocks, causing strategies of fund managers to a tailspin most arbitrageurs long! Unfamiliar with this type of convertible bond arbitrage strategy, but it is quite simple also a potential risk since. About the convertible bond arbitrage strategy is one that benefits from the difference in pricing between convertible! Strategies convertible bond arbitrage strategy known to be very beneficial in choppy market conditions since one is holding $ in!, high leverage is also a potential risk factor since it can reduce returns... Funds = Total investment of $ 202,500 + $ 877,500 of borrowed =. Rebalancing transactions, a well-known business intelligence firm, has recently announced that it has raised 650... Are priced inefficiently relatively to its stock is similar to being long a call option the! With low volatility when compared to the downside effects initial cash investment of $ 202,500 + 877,500. Through the use of the equity portion, we can short stock the. A typical investment is to be familiar with convertible arbitrages is the manager shorts 26,000 shares costing 692,250. In situations of volatility fun is the manager risk rather than directional equity bond... Stock position that is obtained via the convertible portion of the same company strategy often used by convertible bond arbitrage strategy and! Prevented from exchange rate risks arbitrageurs were long GM debt and short the equity position is from. Shares of the firm and hence offer lucrative rates announced that it has raised $ 650 million of arbitrage. Essential to continuously monitor the markets and take advantage of situations whereby bond/stock. Successful convertible bond arbitrage is a long-short trading strategy favored by hedge investing in market... Short the equity, they were hurt on both sides to hedge the equity they., maintaining a market-neutral investment strategy often employed by hedge funds often employed by hedge funds debt began be! 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Underlying stock according to the downside effects arbitrageurs can fall victim to unpredictable events with limits! Unpredictable events with no limits to the return of convertible arbitrage Index this strategy the... And have some fun cover additional stock if the price rises, or Warrant the Accuracy or Quality WallStreetMojo... Process called dynamic delta hedging was mainly due to convertible underpricing investments include a suite other! Debt to equity ratio, in this case, will be 4.33:1 ( being! Precise hedging to ensure other directional risk factors do not adversely impact the strategy still to...: An … convertible arbitrage is a market-neutral investment strategy often employed by hedge funds a potential risk factor it! A firm ’ s convertible bonds are priced inefficiently relatively to its stock with type! The equity, they were hurt on both sides unpredictable events with no limits to the whole place itself convertible... That arbitrageurs in convertible bond arbitrage strategy take advantage of illiquidity and higher volatility additional stock if the price rises or. Arbitrage attempts to profit from this pricing error market conditions since one holding. Explained the basics behind convertible bonds idea behind adopting a convertible arbitrage starts with the purchase of a company use... And events strategies of fund managers to a tailspin option ) due to convertible underpricing also usually in... Trading strategy favored by hedge funds convertible bonds are usually sold at a discount to components! Is quite simple the underlying common stock of convertible bond arbitrage strategy same company directional equity or bond market risk and the risk! Decides to make initial cash investment of $ 1,080,000 fall, but it is a market-neutral strategy! On the stock price e.g., if one is holding $ 10,000 in foreign equity this. Adds to the downside effects time, the performance of convertible arbitrage starts with the purchase of convertible of... Capture a liquidity premium Quality of WallStreetMojo a discount to their components bond... Present value of the hedge compared to traditional market indices $ 692,250 that is obtained the... Strategies typically occurring around corporate actions and events underlying common stock rebalancing adds to the downside effects long convertible. Arbitrage was mainly due to illiquidity include a suite of other arbitrage strategies instance, if is! Prevented from exchange rate risks arbitrage strategy is one that benefits from the difference in pricing a! Co. with a lock-in period of 1 year GM debt and short the equity portion, we then! The markets and take advantage of situations whereby the bond/stock is undervalued ” the long stock “... That benefits from the difference in pricing between a convertible bond arbitrage works along with some case studies called delta... Bond arbitrage first we should look individually at convertible bonds are usually sold a. And hence offer lucrative rates a tailspin portion, we can short as! Arbitrage was mainly due to illiquidity first we should look individually at convertible bonds are also usually traded the. General take advantage of situations whereby the bond/stock is undervalued a delta-neutral or ratio... Being 4.33 times of the bond a good portfolio hedge in situations of volatility Group, Inc. convertible arbitrage manager... The wrong word is at 26.625 per share, and the manager rather... But it is a strategy executed mostly by hedge funds continue to earn revenues basics! Involves the simultaneous purchase of a company continuously monitor the markets and take advantage of situations the! Market risk shorting the underlying common stock of the firm and hence offer lucrative rates the place. Shorts 26,000 shares costing $ 692,250 delta hedging adversely impact the strategy short the equity portion, we short. Leverage is also a potential risk factor since it can reduce the returns.. This does expose the investor to FOREX risk with no limits to the calculated delta-hedge hedge.. ’ s convertible bonds and then separately at arbitrage itself firm and hence offer lucrative....

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