Convertible Bond Arbitrage

What Is Convertible Bond Arbitrage?

Convertible bond arbitrage is a arbitrage strategy that means to capitalize on mispricing between a convertible bond and its underlying stock.

The strategy is generally market neutral. All in all, the arbitrageur tries to generate predictable returns with negligible volatility paying little mind to market course through a combination of long and short positions in the convertible bond and underlying stock.

How Convertible Bond Arbitrage Works

A convertible bond is a hybrid security that can be changed over into equity of the responsible company. It typically has a lower yield than a comparable bond that doesn't have a convertible option, however this is normally balanced by the way that the convertible bondholder can change over the security into equity at a discount to the stock's market price. Assuming the price of the stock is expected to increase, the bondholder will exercise their option to change over the bonds into equity.

[Convertible arbitrage](/change arbitrage) basically includes taking simultaneous long and short positions in a convertible bond and its underlying stock. The arbitrageur desires to profit from any movement in the market by having the proper hedge among long and short positions.

How much the arbitrageur trades of every security relies upon the proper hedge ratio not set in stone 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. When the delta has been estimated, the arbitrageur can lay out their delta position — the ratio of their stock-to-convertible position. This position must be adjusted ceaselessly as the delta changes following changes in the price of the underlying shares.

The issuer of a convertible bond is basically short a call option on the underlying stock at the strike price, though the bondholder is long a call option.

Special Considerations

The price of a convertible bond is especially sensitive to changes in interest rates, the price of the underlying stock, and the issuer's credit rating. Hence, one more type of convertible bond arbitrage includes buying a convertible bond and hedging two of the three factors in order to get exposure to the third factor at an alluring price.

Requirements for Convertible Bond Arbitrage

Convertible bonds are in some cases priced wastefully relative to the price of the underlying stock. To exploit such price differentials, arbitrageurs will utilize a convertible bond arbitrage strategy. In the event that 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.

If the price of the stock falls in value, the arbitrageur will profit from its short position. Since the short stock position neutralizes the potential downside price move in the convertible bond, the arbitrageur catches the convertible bond yield.

Then again, assuming that stock prices rise all things considered, the bonds can be changed over into stock that will be sold at the market value, bringing about a profit from the long position and in a perfect world, compensating for any losses on its short position. Consequently, the arbitrageur can make a relatively generally safe profit whether the underlying share price rises or falls without conjecturing regarding which bearing the underlying share price will move.

On the other hand, on the off chance that the convertible bond is overpriced relative to the underlying stock, the arbitrageur will take a short position in the convertible bond and a simultaneous long position in the underlying stock. Assuming share prices increase, the gains from the long position ought to surpass the loss from the short position. On the off chance that stock prices decline all things considered, the loss from the long position in the equity ought to be not exactly the gain from the price of the convertible bond.

Features

• The benefit of a convertible bond for the issuer is that it typically conveys a lower rate of interest than a comparable bond without the embedded option.
• A convertible bond arbitrage strategy is one that benefits from the difference in pricing between a convertible bond and the underlying stock price.
• The arbitrage strategy takes a long position in the convertible bonds while shorting the stock of the company.
• A convertible bond can be changed over completely to equity in the underlying company at a specific price sooner or later.