Handbook of Finance: Investment Management and Financial Management

Chapter 48. Convertible Bond Arbitrage

FILIPPO STEFANINI

Deputy Chief Investment Officer, Aletti Gestielle Alternative SGR and Professor of Risk Management, Faculty of Engineering at Bergamo University in Italy

Abstract: Convertible bonds are hybrid securities that can be rearranged into many other financial instruments, which, as a result of market forces, can display valuation discrepancies. The goal of the fund manager is thus to identify convertible bonds that have a substantial market price difference compared to the theoretical value and to carry out trades that allow the manager to extract that value, while being protected against market risks. Generally, the risk of interest rate fluctuations is hedged on the convertible long position by using interest rate swaps, and sometimes also the convertible issuer's credit risk is hedged against (risk that the spread widens and issuer default risk) by resorting to credit default swaps.

Keywords: convertible bond arbitrage, delta hedging, volatility trading, delta of a convertible, vega of a convertible, market neutral, balanced convertibles, time decay, theta of a convertible, gamma of a convertible, gamma trading, busted convertible, cash-flow arbitrage, credit default swap, interest rate swap, skewed arbitrage, carry trade, late-stage refinancing plays, multistrategy approach to convertible arbitrage

In his book Arbitrage in Securities, published in 1931, Meyer Weinstein observes that the advent of convertibles, beginning with the ...