Convertible arbitrage
Encyclopedia
Convertible arbitrage is a market-neutral investment strategy often employed by hedge fund
s. It involves the simultaneous purchase of convertible securities
and the short sale
of the same issuer's common stock
.
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. In particular, the equity option embedded
in the convertible bond may be a source of cheap volatility
, which convertible arbitrageurs 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 fluctuations in the price of the underlying stock. However, maintaining a market-neutral position may require rebalancing transactions, a process called dynamic delta hedging. This rebalancing adds to the return of convertible arbitrage strategies.
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 was downgraded at the same time Kirk Kerkorian
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
, 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.
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s. It involves the simultaneous purchase of convertible securities
Convertible security
A convertible security is a security that can be converted into another security. Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined...
and the short sale
Short selling
In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party with the intention of buying identical assets back at a later date to return to that third party...
of the same issuer's common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
.
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. In particular, the equity option embedded
Embedded option
An Embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options...
in the convertible bond may be a source of cheap volatility
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
, which convertible arbitrageurs 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 fluctuations in the price of the underlying stock. However, maintaining a market-neutral position may require rebalancing transactions, a process called dynamic delta hedging. This rebalancing adds to the return of convertible arbitrage strategies.
Risks
As with most successful arbitrageArbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
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 was downgraded at the same time Kirk Kerkorian
Kirk Kerkorian
Kerkor "Kirk" Kerkorian is an American businessman who is the president/CEO of Tracinda Corporation, his private holding company based in Beverly Hills, California. Kerkorian is known as one of the important figures in shaping Las Vegas and, with architect Martin Stern, Jr...
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"
Black Monday (1987)
In finance, Black Monday refers to Monday October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin...
. 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 (1987)
In finance, Black Monday refers to Monday October 19, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong and spread west to Europe, hitting the United States after other markets had already declined by a significant margin...
, 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.