Convertible arbitrage is a

market-neutral An investment strategy or portfolio is considered market-neutral if it seeks to avoid some form of market risk entirely, typically by hedging. To evaluate market-neutrality requires specifying the risk to avoid. For example, convertible arbitrage ...

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 a ...

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 Comm ...

. 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 th ...

to market psychology. In particular, the equity option embedded in the convertible bond may be a source of cheap volatility, which convertible

arbitrageur 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 ...

s 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 The General Motors Company (GM) is an American Multinational corporation, multinational Automotive industry, automotive manufacturing company headquartered in Detroit, Michigan, United States. It is the largest automaker in the United States and ...

was downgraded at the same time

Kirk Kerkorian Kerkor Kerkorian ( hy, Գրիգոր Գրիգորեան; June 6, 1917 – June 15, 2015) was an American businessman, investor, and philanthropist. He was the president and CEO of Tracinda Corporation, his private holding company based in Beve ...

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 Black Monday is the name commonly given to the global, sudden, severe, and largely unexpected stock market crash on Monday, October 19, 1987. In Australia and New Zealand, the day is also referred to as ''Black Tuesday'' because of the time z ...

, 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.

References

External links

{{DEFAULTSORT:Convertible Arbitrage Arbitrage Financial markets

Risks

Controversy

See also

References

Further reading

External links