Convertible Arbitrage Example Let’s take a practical example of how a convertible arbitrage will work: The initial price of a convertible bond is $108.
What are the best convertible bond arbitrage strategies?
One convertible bond arbitrage strategy is volatility trading, which is commonly attempted with convertible bonds that are "at-the-money" - when the underlying stock price is close to the bond's conversion price.
What is an example of arbitrage trading?
Using a very simplified example where we assume a starting delta of 50% and no hedging adjustments, an arbitrageur might buy ¥100 of convertible bonds and simultaneously sell short ¥50 of the underlying stock.
What is convertible arbitrage leverage and how does it work?
Convertible arbitrage leverage can range from two to six times the amount of invested capital. This may seem significant, but it is lower than other forms of arbitrage. Convertible bonds are subject to credit risk. This is the risk that the bonds will default, be downgraded, or that credit spreads will widen.
What are convertible bonds?
Convertible bonds are considered neither bonds nor stocks, but hybrid securities with features of both. They may have a lower yield than other bonds, but this is usually balanced by the fact that they can be converted into stock at what is usually a discount to the stock’s market value.
How convertible bonds affect stock price?
Most issuers hope that if the price of their stocks rises, the bonds will be converted to common stock at a price that is higher than the current common stock price. By this logic, the convertible bond allows the issuer to sell common stock indirectly at a price higher than the current price.
Do convertible bonds increase stock price?
However, convertible bonds tend to offer a lower coupon rate or rate of return in exchange for the value of the option to convert the bond into common stock.
What is a convertible bond arbitrage?
Convertible bond arbitrage is typically a delta-neutral strategy in which the investor purchases a convertible bond and simultaneously sells short the underlying stock in an amount equivalent to the theoretical equity delta of the bond (calculated using a convertible bond pricing model).
How do convertible arbitrage make money?
If the convertible bond is cheap or undervalued relative to the underlying stock, the arbitrageur will take a long position in the convertible bond and a simultaneous short position in the stock. In the event that the price of the stock falls in value, the arbitrageur will profit from its short position.
How are convertible bonds priced?
A convertible bond's investment value is its intrinsic value based on the bond's fixed-income characteristics, such as prevailing interest rates, including the yield on the issuer's nonconvertible bonds. This investment value is a floor below which the convertible bond price rarely falls.
What is the conversion price of the stock?
The conversion price is the price per share at which a convertible security, such as corporate bonds or preferred shares, can be converted into common stock. The conversion price is set when the conversion ratio is decided for a convertible security.
How does bond arbitrage work?
An arbitrage bond is the refinancing of a municipality's higher interest rate bond with a lower interest rate bond prior to the higher interest rate bond's call date. The strategy of issuing arbitrage bonds is particularly effective when prevailing interest rates and bond yields in the economy are declining.
Who invented convertible arbitrage?
Weinstein gave a description of a simple convertible bond arbitrage trade in his 1931 book, Arbitrage in Securities. Thorp and Kassouf developed the trade significantly in their book from 1967, Beat the Market, foreshadow- ing the Black–Scholes–Merton formula for option pricing.
What is the typical strategy of most convertible arbitrage hedge funds?
A convertible arbitrage hedge fund is typically long on convertible bonds and short on a proportion of the shares into which they convert. Managers try to maintain a delta-neutral position, in which the bond and stock positions offset each other as the market fluctuates.
How do you hedge a convertible bond?
A convertible hedge is created by buying a convertible debt security and then shorting the conversion amount of stock. A convertible hedge locks in a return and is unwound when the debt security is converted to stock to offset the short stock position.
What is a negative arbitrage?
Negative arbitrage occurs when a borrower pays off its debts at a higher interest rate than the rate the borrower earns on the money set aside to repay the debt. Basically, the borrowing cost is more than the lending cost.
How do you buy convertible bonds?
How to Buy Convertible Bonds. There are several ways to invest in convertible bonds. If you want to buy individual bonds, you can do so through a brokerage with a bond desk and a specialist in convertibles. Many brokerages, however, don't offer direct investments in convertibles because they're less common.
Do convertible notes dilute shares?
In the absence of protections, convertible bonds almost always dilute the ownership percentage of current shareholders. The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings.
What are the advantages of convertible bonds?
Convertible bonds typically carry lower interest rates payments than straight corporate bonds—the savings in interest expense can be significant. Investors accept the lower interest payments because the conversion option offers the opportunity to benefit from increases in the stock price.
What happens when a convertible bond is called?
Forced conversion usually occurs when the price of the stock is higher than the amount it would be if the bond were redeemed. Alternatively, it may also occur at the bond's call date. A reversible convertible bond allows the company to convert it to shares or keep it as a fixed income investment until maturity.
Why do companies issue convertible bonds?
Convertible bonds are typically issued by companies that have high expectations for growth and less-than-stellar credit ratings. The companies get access to money for expansion at a lower cost than they would have to pay for conventional bonds.
What Is Convertible Bond Arbitrage?
Convertible bond arbitrage is an arbitrage strategy that aims to capitalize on mispricing between a convertible bond and its underlying stock.
What is arbitrage strategy in convertible bonds?
The arbitrage strategy takes a long position in the convertible bonds while shorting the stock of the company.
What happens when a convertible bond falls in value?
In the event that the price of the stock falls in value, the arbitrageur will profit from its short position.
What is the difference between a convertible bond and a call option?
The issuer of a convertible bond is essentially short a call option on the underlying stock at the strike price, whereas the bondholder is long a call option.
What happens when a bondholder exercises their option to convert the bond into equity?
If the price of the stock is expected to increase, the bondholder will exercise their option to convert the bonds into equity. Convertible bond arbitrage essentially involves taking simultaneous long and short positions in a convertible bond and its underlying stock.
How does arbitrage work?
How Convertible Bond Arbitrage Works. A convertible bond is a hybrid security that can be converted into equity of the issuing company. It typically has a lower yield than a comparable bond that does not have a convertible option, but this is usually balanced by the fact that the convertible bondholder can convert the security into equity ...
How does an arbitrageur determine the delta?
How much the arbitrageur buys and sells of each security depends on the appropriate hedge ratio which is determined by the delta. Delta is defined as the sensitivity of the price of a convertible bond to changes in the price of the underlying stock. Once the delta has been estimated, the arbitrageur can establish their delta position—the ratio ...
What are the risks of convertible arbitrage?
It is terribly important to understand that while arbitrage strategies are designed to mitigate volatility (changes in asset prices), there are still many other types of risk that we must consider. This is especially true in the case of convertible arbitrage, because there may be stipulations in the contract that you will have to hold the convertible bond for a length of time before converting to common stock. Therefore, within that time, the arbitrageur must be able to assess and plan for any significant market and economic changes that may occur within the time conversion is allowed.
When did convertible arbitrage start?
Convertible arbitrage started in the 1960s. Many hedge funds have been deploying this strategy and have innovated on top of it. That said, learning this strategy is useful as it hones your foundation for spotting opportunities between different financial products in the market.
What are the different models used to price convertible bonds?
There are many different models used to price convertible bonds including both closed-form and numerical solutions. As always, closed-form solutions carry more assumptions and can be restrictive in practice. On the other hand, even simpler numerical solutions such as lattice methods, or Monte Carlo simulations, include path-dependent payoff structures allowing more flexibility and generalizations with convertible bond features. Furthermore, Monte Carlo and lattice methods are relatively easy to implement.
What happens to convertible bonds after they are issued?
After they are issued, the lack of liquidity of the convertible bond encourages further discount from the fundamental price on trades occurring before the maturity date. Once the bond matures however, an investor will receive the current fundamental value of the bond.
Why do corporations issue convertible bonds?
Functionally speaking, issuing convertible bonds allow corporations to access funds quickly relative to traditional equity and debt offerings. On the other hand, investors can use convertible bonds to hedge the underlying equity, credit, and interest rate risk.
What is a convertible with higher vega?
Convertibles with higher vega are more sensitive to changes to volatility, since this strategy takes advantage of this, they are sometimes called volatility trades. For vega trading we long the convertible bond and short appropriate options on the underlying stock that are trading at high levels of volatility.
Why are convertible bonds called latent call options?
So, the latent call option in a convertible bond still makes the bond valuable to investors even at lower coupon rates. Even so, to attract buyers and raise capital quickly for the firm, convertible bonds are often issued at prices below the fundamental value of the debt and call option.
How does a convertible arbitrage fund hedge the equity component of a convertible bond?
Convertible arbitrage funds build long positions of convertible bonds and then hedge the equity component of the bond by selling the underlying stock or options on that stock. Equity risk can be hedged by selling the appropriate ratio of stock underlying the convertible option. This hedge ratio is known as the "delta" and is designed to measure the sensitivity of the convertible bond value to movements in the underlying stock.
What is convertible bond risk?
Convertible bonds are subject to credit risk. This is the risk that the bonds will default, be downgraded, or that credit spreads will widen. There is also call risk. Last, there is the risk that the underlying company will be acquired or will acquire another company (i.e., event risk), both of which can have a significant impact on the company's stock price and credit rating. These events are only magnified when leverage is applied.
Why do convertible bonds have a high delta hedge ratio?
These convertibles then trade more like stock than they do a bond. Consequently a high hedge ratio, or delta, is required to hedge the equity risk contained in the convertible bond. Convertible bonds that trade at a premium to their conversion value are highly valued for their bond-like protection. Therefore, a lower delta hedge ratio is necessary.
How long does a hedge fund manager hold a convertible arbitrage?
Therefore, if the hedge fund manager holds the convertible arbitrage position for one year, he expects to earn interest not only from his long bond position, but also from his short stock position. The catch to this arbitrage is that the price of the underlying stock may change as well as the price of the bond.
What is arbitrage in hedge fund?
Hedge fund managers tend to use the term "arbitrage" somewhat loosely. Arbitrage is defined simply as riskless profits. It is the purchase of a security for cash at one price and the immediate resale for cash of the same security at a higher price. Alternatively, it may be defined as the simultaneous purchase of security A for cash at one price ...
Why is leverage important in shorting?
Additionally, leverage is inherent in the shorting strategy because the underlying equity stock must be borrowed to be shorted. Convertible arbitrage leverage can range from two to six times the amount of invested capital. This may seem significant, but it is lower than other forms of arbitrage.
Who gets the short rebate?
10 The short rebate is negotiated between the hedge fund manager and the prime broker. Typically, large, well-established hedge fund managers receive a larger short rebate.
What is convertible arbitrage?
The idea behind convertible arbitrage is that a company’s convertible bonds are sometimes priced inefficiently relative to the company’s stock. Convertible arbitrage attempts to profit from this pricing error.
What is equity long short?
An equity long-short strategy is an investing strategy which involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value.
Does convertible arbitrage increase returns?
In summary, convertible arbitrage, like other long-short strategies, may help increase returns in difficult market environments, but it isn’t without risks. As a result, investors considering a hedge fund that uses convertible arbitrage may want to carefully evaluate whether the potential return is balanced by the potential risks.
Is convertible arbitrage risky?
Convertible arbitrage is not without risks. First, it is trickier than it sounds. Because one generally must hold convertible bonds for a specified amount of time before they can be converted into stock, it is important for the convertible arbitrageur to evaluate the market carefully and determine in advance if market conditions will coincide with the time frame in which conversion is permitted.
What is arbitrage in trading?
Arbitrage is a widely used trading strategy, and probably one of the oldest trading strategies to exist. Traders.
What are some examples of arbitrage?
A very common example of arbitrage opportunities is with cross-border listed companies. Let’s say an individual owns stock in Company ABC, listed on Canada’s TSX, that is trading at $10.00 CAD. At the same time, the ABC stock listed on the NYSE trades at $8.00 USD. The current CAD/USD exchange rate is 1.10. A trader could purchase shares on the NYSE for $8.00 USD and sell shares on the TSX for $10.00 CAD. This would give him a profit of $1.09 USD per share.
What are the conditions of arbitrage?
Arbitrage may occur if the following conditions are met: Asset price imbalance: This is the primary condition of arbitrage. The price imbalance can take various forms: In different markets, the same asset is traded at different prices. Assets with similar cash flows.
What is arbitrage in financial terms?
What is Arbitrage? Arbitrage is the strategy of taking advantage of price differences in different markets for the same asset. Types of Assets Common types of assets include current, non-current, physical, intangible, operating, and non-operating. Correctly identifying and. . For it to take place, there must be a situation ...
Why should a trade be executed simultaneously?
Simultaneous trade execution: The purchase and sale of identical or equivalent assets should be executed simultaneously to capture the price differences. If the transactions are not executed simultaneously, the trade will be exposed to significant risks.
What is convertible bond?
convertible bond is a corporate bond that can, at the option of the holder, be converted into shares of the issuer’s common stock. Convertible bonds are hybrid securities—essentially a corporate debt obligation that comes packaged with an equity call option. Each bond has a “conversion price,” which is the stock price at which a convertible bondholder is indifferent between redeeming the bond (i.e., receiving par or face value in most cases) and receiving shares of common stock. For example, if a convertible bond has a face value of $1,000 to be paid at maturity and the conversion ratio is 50 shares per bond, the convertible bondholder will be indifferent between receiving the $1,000 face value versus 50 shares of common stock when the stock price is $20 ($1,000 par value = 50 shares × $20 stock price) at the time of maturity.
How cheap were convertible bonds in 2008?
As the credit crisis unfolded, convertible bonds slowly, but inexorably, cheapened. Median bond cheapness rose from 0.9 percent at the end of 2007 to 1.4 percent at the end of February 2008. Despite the collapse of Bear Stearns in March 2008, the convertible market remained relatively healthy, with cheapness only growing to 1.7 percent by the end of March. As investors became more risk averse (and perhaps less willing to hold illiquid credit assets), bonds cheapened dramatically over the summer, ending the second quarter at 2.3 percent cheap. At that level, they were about as cheap as they had been during the LTCM crisis of 1998 and the convertible bond sell-off of 2005. By the end of August, the bonds were even cheaper, trading 3.7 percent below fundamental value, representing a significant apparent “arbitrage,” though in reality only foreshadowing the far more substantial events that were yet to come.
What happened to the convertible bond market in 2008?
What happened, in essence, is that financing was withdrawn from the convertible bond market, causing problems for arbitrageurs who faced a mismatch between the relative illiquidity of their convertible bond portfolios and the short-term financing that supported those positions.
What is perfect arbitrage?
“perfect arbitrage” is an investment that offers riskless profit. Convertible arbitrage, needless to say, is not perfect. Historically, convertible arbitrageurs generally have lost money in two ways. First, through default. When a convertible bond defaults, its fundamental value is dramatically reduced. In principle, an arbitrageur’s short exposure (short both the equity option component and the straight debt component) should offset this loss. As noted above, however, the straight debt can be difficult to hedge in practice and there may be basis risk between the straight debt component of the bond and the instrument used to short straight debt exposure. This basis risk can lead to portfolio losses, but the impact of any single bond defaulting can be significantly mitigated by holding a diversified portfolio of convertible bonds, each appropriately hedged. The ultimate loss from an individual convertible bond default depends significantly on the path of the default (a sudden shock versus a slow death) and the ultimate recovery rate realized by bondholders.
Is arbitrage a low risk strategy?
Convertible arbitrage is an excellent example of a relatively low-risk arbitrage. In theory, a perfect arbitrage is supposed to offer riskless profits. In practice, there are no perfect arbitrages, but arbitrage strategies of all stripes offer the possibility of profits, generally with low risk relative to the possible return and also with low correlation to the direction of the markets.
