CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

34.6 CONVERTIBLE ARBITRAGE IN PRACTICE: STRIPPING AND SWAPPING

Once equity, volatility, and interest rate risks have been eliminated from the convertible position, the arbitrageur is left with credit risk, or the possibility of changes to credit spreads. This risk is important because the majority of convertible issuers are below investment grade, at least in the United States. Moreover, many convertible bonds are unsecured, subordinated, and issued by firms with high earnings volatility, high leverage, or intangible assets. These bonds are particularly sensitive to the business cycle, so the arbitrageur cannot ignore credit risk.

Short selling the stock provides a partial hedge against credit risk, for as spreads widen, stock prices generally decline. However, this hedge is imperfect and difficult to calibrate precisely. Moreover, to entirely eliminate the credit-spread risk with a short stock position, the arbitrageur would need to short considerably more stock than the delta hedge calls for, placing the position at considerable risk should spreads not widen and stock prices appreciate. One alternative is to sell short a straight bond of the same issuer. This is usually an effective hedge against credit risk, but it is feasible only if other bonds from the same issuer are still actively traded and can be borrowed easily. This is clearly not the case for all issuers. Using credit default swaps might also be considered, but this practice exposes the arbitrageur to a serious call ...