Investment Strategies of Hedge Funds

6

Convertible Bond Arbitrage

Convertible bond arbitrage should be seen as a real business. In its simplest form, it’s a business of lending money to corporations in the form of convertible debt and collateralizing that loan with common stock.

A hedge fund manager

Convertible bonds are bonds that give their holders the right to periodic coupon payments and, as of a fixed date, the right to convert the bonds into a fixed number of shares. If the bond-holder decides to exercise his conversion right, instead of being paid back the par value of the bonds, he will receive a fixed number of shares in exchange. For example, in 2003 Siemens Finance BV issued €2.5 billion of bonds convertible into Siemens AG shares paying a fixed annual coupon of 1.375 %, due on 6th April 2010.

In most cases these shares are common stock of the issuer, yet sometimes it can be shares from another company, should the issuer decide to sell an equity investment it holds in another company by issuing a convertible. For example, in 2003 Unicredito Italiano Bank (Ireland) PLC issued €1.148 billion of bonds convertible into Generali shares paying a fixed annual coupon of 2.5 %, due on 19th December 2008 with an exercise date for the conversion right as of 19th December 2005.

Convertibles are ideal securities for arbitrage because the convertible itself, namely the underlying stock and the associated derivatives, are traded along predictable ratios and any discrepancy or misprice would give rise to arbitrage ...