Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Chapter 7

Convertible Arbitrage Strategies

The hedge fund style that looks to exploit pricing inefficiencies related to convertible securities is commonly referred to as convertible arbitrage. This style seeks primarily to exploit inefficiencies in the pricing of convertibility feature or options component of a convertible bond instrument and the relationship between implied credit spread and equity volatility. A convertible bond is a hybrid security with features of both debt and equity. Managers in this category will use a complex set of analytical, fundamental, credit, and trading procedures to price and trade the long dated imbedded options component of the bond either in tandem with or separately from it's fixed income and credit components. Many managers are interested in owning a portfolio of cheap options on the equity of a diversified group of companies and trading volatility rather than owning the implicit interest rate, credit, and equity risk that are also part of a convertible bonds pricing structure, while others may wish to take a credit view if the implied credit spread is wider than comparable credit instruments in the company's capital structure or for similar credits in its sector.

Convertible arbitrage, in its simplest form, entails buying a convertible bond while simultaneously shorting its underlying stock. The concept of convertible arbitrage has been around for almost as long as convertible bonds themselves. Convertible bonds date back to the 1800s, when ...