Convertible Arbitrage

CFA Level III Portfolio Management
#1

In the curriculum convertrable arbitrage is described as: buying convertable bonds and hedging the equity component of the bonds’ risk by shorting the associated stock.

The risks include: changes in the price of the underlying stock, changes in expected volatility, changes in level of interest rates, changes in the credit standing of the issuer.

The strategy profits when: expected volatility of the underlying increases or price of the underlying increases rapidly.

I have the following queries on this:

  • Could somebody please kindly explain the risks and the profit by giving an example?

  • Under which category falls this strategy? (Relative value, event driven etc…)

Thank you in advance!

#2

I can try to answer your first question:

In a convertible boond arbitrage, you hold a position in a call option on the stock, so part of the value of the bond comes from holding that option. You gain in two ways from a convertible bond:

  1. The option when the price of the stock goes up (because you can convert to stock at a fixed price and gain from option.

  2. The price of the bond itself.

So… let’s go back to the bond example. rates can start dropping, but the stock might not rise as you expected. So, you start benefiting from the appreciation of the bond itself. The bond value goes up, but your option value goes down.

Now what if rates drop and the value of the stock goes up? If that happens, the bond value goes up and so does the option, so the value is even greater.

I hope this makes sense

#3

Very well explained! Thanks

#4

I believe this falls under event driven;

this is my understanding, you hold a convertible position of a stock which is heading bankruptcy.

When low interest rates: the company does well < should not default ; the stock performs - call pays off + bonds do well low ir environment = good and good

comany is crashing: bought bond at bottom price, the company is salvaged and as bond holder you receive a higher price than the price at which u bought = call neutral and good

correct me if necessary

#5

If there are risks, it ain’t arbitrage.

(Yes: I know that they’ve bastardized the term. Shame on finance-types.)

#6

Relative value in my notes. Merger arbitrage is event driven. I think you are describing distressed securities which is event driven.

#7

I would go with relative value. The bond participation in the stock movement is where the manager can add some value. You can fully hedge using the stock or tilt the ratio one way or another depending on the views. A certain bond participates in more of the stock upside than another issue could make it more attractive to the manager