CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

34.1 EVOLUTION OF THE CONVERTIBLE ARBITRAGE STRATEGY

Convertible arbitrage is a classic arbitrage strategy that attempts to exploit inefficiencies in the pricing of convertible bonds relative to their underlying stocks. Initially, convertible arbitrage started as a niche business for dedicated proprietary trading desks in large investment banks. Convertible arbitrageurs typically bought cheap convertible bonds and hedged their market risk by selling short the underlying stocks. Subsequently, thanks to the development of sophisticated option pricing models and the availability of credit derivatives, the strategy expanded to include volatility and credit trading elements. As of year-end 2011, Hedge Fund Research (HFR) reports that dedicated convertible arbitrage funds represent less than 3% of the assets managed by hedge funds. Though quite small in comparison to, say, equity long/short, convertible arbitrage shares important features common to a variety of hedge fund strategies and serves as a valuable example.

In its simplest form, the convertible arbitrage strategy involves purchasing convertible bonds and hedging away various risks associated with the instrument, including equity risk, credit risk, and interest rate risk. The ultimate objective is to isolate underpriced options embedded in convertible bonds. Naturally, the question arises as to why corporations should issue underpriced securities. The answer is simple. In addition to raising capital through the issuance of debt, ...