Understanding Convertible Arbitrage

Understanding convertible arbitrage requires a knowledge of convertible securities and is a strategy often used by hedge funds. Convertible arbitrage is when one (a convertible arbitrageur) makes a profit by buying convertible securities and simultaneously short selling common stock from the same issuer. This profit is made possible due to a pricing error made in the conversion of a convertible security. These errors can sometimes be due to illiquidity or market psychology.

Convertible Securities in Arbitrage

Convertible securities are securities that can be converted into another security at a set time and price. Typically, these securities are bonds that can be converted into stock. The tradeoff for convertible securities having lower yields is that you are usually able to convert them into stock at a discount to the market value of that stock. This gives you both the safety of the bond, and the ability to employ stock speculation if you predict that the stock will go up. When a convertible bond is priced ineffectually in relation to its stock, that is when the possibility of convertible arbitrage arises.

Example of Convertible Bonds and Short Selling

This example will explain the positions you take when you buy convertible bonds and short sale the same company’s stock. You, as a trader working for a hedge fund, decide to buy a company’s convertible bond as well as short sell that same company’s stock. There are two typical scenarios that will demonstrate your positions: a) the price of the stock goes down or b) the price fluctuates upward. If the price of the stock goes down, then you benefit in your short sale. If the price of the stock goes up, then you simply convert your bond into stock and hopefully compensate for any losses on the short sale of that stock.

Risks

One thing to note about convertible bonds is that the timing of convertible arbitrage can be very complicated to pull off successfully. Usually, you have to hold convertible bonds for a specified amount of time so you need to make sure that time corresponds to the market conditions necessary. Tremendous unforeseeable market events can also throw off the attempts of a convertible arbitrageur. The market crash of 1987, for example, created market liquidity conditions that forced many convertible bonds to decline even lower than the stocks that they were convertible to. More recently, in 2005, many convertible arbitrageurs had a long position in General Motors convertible bonds as well as a short position in their stock. Then, an offer for GM’s stock came from Kirk Kerkorian, who is a billionaire investor. The result of the offer from Kerkorian, who was trying to buy GM stock while its debt was being downgraded, was that the convertible arbitrageurs suffered losses on both accounts. They lost money, not only on their long positions of convertible bonds, but also on their short sale positions of the company’s stock. Convertible arbitrage may be useful in creating higher returns in certain market conditions, but arbitrageurs also need to be wary of the potential risks it carries with it.

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