the trading strategy of buying a convertible securities portfolio and hedging part of the equity risk by short-selling the underlying common stock.
Convertible Arbitrage Details
A convertible security is an investment that may be modified to have the properties of a different type of investment. It is usually a bond that offers the trader or investor a choice to change it into a stock. Bonds are debt instruments that allow companies to build funds and pay interest during the security's entire lifespan. Similarly, there is a particular amount to which a bond is converted at a preset point in time.
Convertible securities are hybrid securities that, by definition, can behave like two different investments. For instance, a convertible bond will have the qualities of a bond, such as an interest rate and a stock, which can be sold at the prevailing market price. However, convertible bonds generally come with a lower yield or interest rate since the investor will have the freedom to decide whether to keep them until they mature or turn them into stocks, as the company's stock price increases to a previously determined level. Prices for convertible bonds fluctuate. They depend on interest rates, the issuer's credit score, general changes in stock price.
Example of Convertible Arbitrage
Let's consider a stock trading in the market at $10.10, with a convertible issue whose face value is $100. We can convert this amount into ten shares at $10 while the security keeps trading at $100. With no impediments to conversion, an arbitrage trader would purchase the convertible and short the stock simultaneously for riskless profits(transaction costs excluded) of $1 for each of the convertible's $100 face value.
The trader then gets $10.10 for every short-sold share and immediately takes care of the short position by making the convertible security into ten shares priced at $10 apiece. This would produce an outcome where each $100 face value of the convertible would gain a $1 profit. One dollar does not look significant, but if a 1% riskless profit were made on $100 million, this would easily rack up $1 million in total profits.
Significance of Convertible Arbitrage
The idea behind convertible arbitrage is to boost profit potential through the long-short position, which comes with minimum risk. A decrease in the stock's value gives the trader advantage. On the other hand, since the convertible bond has a fixed income rate, it carries a small amount of risk.
However, if the stock profits grow, the short stock position loss will be minimal as the convertible security gains will provide enough buffer. If a stock is trading at par and not moving upward or downward, the convertible security will keep paying a constant coupon rate, covering the costs of maintaining the short stock.
Another reason investors are interested in convertible arbitrage is the erroneous pricing of convertible bonds with respect to the stock. The company will offer attractive rates in an attempt to entice people to invest in its debt stock, and then profit from the pricing inefficiency.