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At first glance, corporations wishing to raise capital seem to have an almost infinite variety of instruments at their disposal – most of them springing from the fertile imagination of investment banks. But in reality, most if not all of these esoteric instruments can be seen as a dynamic combination of two basic types of securities, namely debt and equity. In a nutshell, corporations just have to choose between issuing debt and issuing equity. Issuing debt is not dilutive but sets stringent requirements in terms of mandatory coupon payments. Issuing equity dilutes existing equity holders but has no imposed cost, as dividends are not mandatory.
Convertible securities are a perfect example of such a combination. Basically, convertible securities are bond-like instruments that can be converted into equity at the discretion of their owner. For several reasons that are discussed below, convertible securities are often issued below their fair value. This creates an opportunity for arbitrage that attracts hedge funds like a magnet. Initially, the funds’ favourite strategy consisted in purchasing undervalued convertibles and selling short the stock of the issuer to hedge the associated equity risk. Over the years, the strategy has evolved to include directional bets on credit risk, volatility, convexity, etc. But before going into these more complex variations, let us start by reviewing ...