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Convertible Arbitrage A convertible arbitrage is a long-short trading strategy favored byhedge fundsand large-scale traders. Such a strategy involves taking a long strategy in a convertible security with a simultaneous short position in the underlying common stock, for the purpose of capitalizing pricing differences between the two securities. A convertible security is one which can be converted into another form such as a convertible preferred stock which can be changed from aConvertible Preference shareto an Equity share/Common stock.

In this article, we discuss Convertible Arbitrage in detail

The rationale for adopting a convertible arbitrage strategy is that thelong-short position enhances the possibility ofgains is made with a relatively lower degree of risk. If the value of the stock declines, the arbitrage trader will benefit from the short position in stock since it is an equity and value flows in the direction of the market. On the other hand, the convertible bond or Debentures will have limited risks since it is an instrument having a fixed rate of income.

However, if the stock gains the loss on the short stock position will be capped since it will be offset by the profits on the convertible security. 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 costs of holding the short stock.

Another idea behind adopting a convertible arbitrage is that a firmsconvertible bonds are priced inefficiently relatively to the companys stock.This can be since the firm may lure investors to invest in the debt stock of the firm and hence offer lucrative rates. The arbitrage attempts to profit from this pricing error.

View CourseRelated CoursesFixed Income CourseBond Trading CourseFixed Income Mathematics Course

A critical concept to be familiar with convertible arbitrages is the hedge ratio. This ratio compares the value of the position held through the use of the hedge in comparison to the entire position itself.

For e.g. if one is holding $10,000 in foreign equity, this does expose the investor to FOREX risk. If the investor decides to hedge $5,000 worth of the equity with a currency position, hedge ratio is 0.5 (50/100). This culminates that 50% of the equity position is prevented from exchange rate risks.

Convertible arbitrage is trickier than it sounds. Since one generally must hold the convertible bonds for a specified amount of time before conversion into equity stock, it is critical for the arbitrageur/fund manager to evaluate the market carefully and determine in advance if market conditions or any other macroeconomic factors can have an impact during the time frame in which conversion is permitted.

For instance, if a fund has acquired a convertible instrument of ABC Co. with a lock in period of 1 year. However, post 1 year the countries Annual budget is going to be announced whereby they are expected to impose a 10% Dividend Distribution tax on the dividends announced by the company on the equity shares. Such a measure will have an impact on the market and also the question of holding a convertible stock over the long run.

Arbitrageurs can fall victim to unpredictable events with no limits to the downside effects. One instance is during 2005, when manyarbitrageurs held long positions in General Motors (GM) convertible bonds and short positions in GM stock. The expectation was that present value of GM stocks will fall but the debt will continue to earn revenues. However, the debt began to be downgraded by the credit rating agencies and a billionaire investor attempted to make bulk purchase of their stocks causing strategies of fund managers to a tailspin.

Convertible Arbitrage faces the following risks

: Majority of the convertible bonds can be below investment grade or not rated at all promising extraordinary returns, hence a significant default risk exists.

Convertible bonds with longer maturity are sensitive to interest rates and while stocks with a short position are a definite hedging strategy, lower hedge ratios may require additional protection.

The manager may incorrectly value a Convertible bond resulting in the arbitrage strategy to be questioned. If the valuations are wrong and/or credit risk increases, the value from bond conversion could be reduced/eliminated. Manager risk is also inclusive of the firms operational risk. The managers ability to enter/exit a position with minimal market impact will have a direct impact on the profitability.

The prospectus provides many degrees of potential risks arising in such strategies like early call, special dividends expected, late interest payment in the event of a call etc. Convertible arbitrageurs can best protect themselves by being aware of the potential pitfalls and by adjusting the hedge types to adjust such risks. One also needs to be aware of the legal implications and volatility applicable in the stock markets as well as the bond markets.

Convertible arbitrage opportunities often cross multiple borders which also involve multiple currencies and exposing various positions to currency risks. Arbitrageurs will thus need to employ currency futures or forward contracts to hedge such risks.

Lets take a practical example of how a convertible arbitrage will work:

The initial price of a convertible bond is $108. The arbitrage manager decides to make initial cash investment of $202,500 + $877,500 of borrowed funds = Total investment of $1,080,000. The debt to equity ratio, in this case, will be 4.33:1 (Debt being 4.33 times of the equity investment amount).

Share price is at 26.625 per share and the manager shorts 26,000 shares costing $692,250. Also, Hedge ratio of 75% is to be maintained, and therefore the bonds ratio of conversion will be (26,000/ 0.75) = 34,667 shares.

The Total return can be shown with the help of the below table:

1.25% interest on the proceeds of $692,250 based on the initial hedge ratio of 75% [26,000 shares sold at $26.625 = $692,250, relative to the 34,667 shares of the bond equivalency].

1%dividend yieldon $692,250 (i.e. 26,000 shares)

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. Loss of $4.375*26,000 shares]

(Total $ return of $40,431 is a 20% ROE of $202,500)

The sources of the ROE can be shown with the help of the below table:

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%

Total Return of $40,431 earned/bond price of $1,080,000 = 3.8%

Contribution from Leverage is very significant.

Convertible Arbitrage Fund Managers Expectations

In general, convertible arbitrageurs look for convertibles that exhibit the following characteristics:

An underlying stock which demonstrates above average volatility as this gives them a greater likelihood of earning higher profits and adjusting the hedge ratio.

A conversion premium is an additional amount paid for a convertible security over its conversion value measured in %. In general, a convertible with conversion premium of 25% and below the same is preferred. A lower conversion premium indicates lower interest rate risk and credit sensitivity both of which very difficult to hedge than equity risk.

Low or No Stock dividend on the Underlying shares

Since the hedge position is short on the underlying shares, any dividend on the stock must be paid to the long stock owner since the anticipation of the strategy is the falling of share price.Such an instance will create negative cash flow in the hedge.

High gamma means how rapidly the delta changes. Delta is the ratio comparing the change in the price of underlying asset to the corresponding change in the price of a derivative contract. A convertible with ahigh gamma offers dynamic hedging opportunities more frequently, thus offering possibility of higher return.

Since the hedged convertible position is a long position, the arbitrageur will be seeking issues which are undervalued or trading at implied volatility levels below average market returns. If the convertible possesses the future of coming back to normal returns, then this will be an appropriate opportunity for the manager to cash in.

Issues which are highly liquid are preferred by the arbitrageur since it can be used for quickly establishing or closing a position.

There are many convertible arbitrage trades but some of the common ones are:

These are highly equity sensitive trades which are in-the-money, trading conversions of less than 10% premiums. These are convertibles with a high delta, reasonable credit quality and a solid bond floor. Bond floor is the rate which the bonds are offering and is a fixed rate of return (bond component of a convertible security based on its credit quality, expressed in %).

Such trades arise by establishing a delta-neutral or possible biased position involving convertible security with a reasonable credit quality and simultaneous short sale of the underlying stock. Since such stocks are volatile due to their nature, this strategy requires careful monitoring by dynamically hedging the position i.e. continuous buying/selling shares of the underlying common stock.

Also known as volatility trades involves establishing a long position in the convertibles and selling appropriately matched call options of the underlying stock trading at high volatility levels. This also requires careful monitoring of the positions involving listed call options as the call option strike price and the expirations must match as close as possible to the terms of the convertible security.

The aim of such trades is to garner maximum cash flows from the arbitrage opportunities. This strategy focuses onconvertible securities with a reasonable couponor dividend income relative to the underlying common stock dividend and conversion premium. It offers profitable trading alternatives where the coupon from the long position or dividend/rebate received from the short position offsets the premium paid over a period of time.

The convertible arbitrage strategy has produced attractive returns over the past 2 decades which are not correlated with the individual performance of the bond or the equity market. The deciding factor for the success of such strategy is the manager risk rather than directional equity or bond market risk. Additionally, high leverage is also a potential risk factor since it can reduce the returns earned.

In 2005, investor redemptions had a significant impact on the strategys returns, although the maximum drawdown remains significantly less as compared to traditional equity and bond markets. This is in contrast to the good performance for the convertible arbitrage strategy during 2000-02 when the markets were highly volatile due to the dot com crisis. The strategy still appears to be a good portfolio hedge in situations of volatility.

Such strategies are known to be very beneficial in choppy market conditions since one is required to take advantage of price differences. It is essential to continuously monitor the markets and take advantage of situations whereby the bond/stock is undervalued. The returns from the bond is 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.

Filed Under:Derivatives BasicsFixed Income BasicsRisk Management Basics

worked as JPMorgan Equity Analyst, ex-CLSA India Analyst ; edu qualification – engg (IIT Delhi), MBA (IIML); This is my personal blog that aims to help students and professionals become awesome in Financial Analysis. Here, I share secrets about the best ways to analyze Stocks, buzzing IPOs, M&As, Private Equity, Startups, Valuations and Entrepreneurship.

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