Convertible Bond Arbitrage involves taking a long position in a convertible bond and a short position in the underlying common stock. The short stock position “hedges” the long stock position that is obtained via the convertible portion of the bond. This is similar to being long a call option on the stock. Therefore, the short stock position is not necessarily a reflection of the perceived value of the company, but simply used as a hedge. By accurately pricing the convertible bond, traders are able to set up an arbitrage strategy.
The strategy profits from the volatility of the stock price and the constant buying and selling of stock to maintain a hedged position to remain market neutral. As the underlying stock moves up, the mechanics of the call option within the bond generates a synthetic long position in the underlying stock. The holder becomes longer at an ever-increasing rate due to the gamma in the option. This requires the hedging of this synthetic long stock position by shorting the underlying stock in the open market. When the stock declines the reverse is true and the arbitrageur buys the underlying stock. Thus, covering the short position. This constant hedging by buying and selling ensures the holder is always market neutral. Profit is derived from “scalping”, ie constant trading back and forth. It is common to see smaller stocks “range bound” as these players dominate trading in the market.
Convertible Bond Arbitrage in Practice
For more information on trading options, see what most options traders refer to as the bible Option Volatility and Pricing: Advanced Trading Strategies and Techniques, 2nd Edition.
The benefit to the company is the cheaper interest cost paid on the bond by issuing (or including) a stock option. However, should the stock price rise considerably, the company will ultimately issue stock at a comparably cheaper price known as the exercise price. Thus, there is a trade-off between cheaper financing now, versus potential expensive dilution later.
Typically, a Convertible Bond Arbitrage strategy is performed by hedge funds. As such, it may include an extra layer of complexity by shorting an interest rate product to reduce risk even further. This improves the market neutrality of the trade.
Further Information
For more information see Short Selling Activities and Convertible Bond Arbitrage.
