Abstract. Historically, about 1% of convertible bonds default each year, which is lower than the default rate for non–investment grade bonds. Convertible bond arbitrage wherein a trader aims to reap benefits from the convertible bonds’ mispricing and the underlying stocks. However, like anything in the financial world, there are still risks involved. Lye Heng possessed 13 years of working experience in the banking industry and is a derivative specialist. Risks. Therefore, while the papers give a better understanding of the risks involved in each strategy, they fail to look at the effects that fees have on the returns and the implications for reported hedge fund returns. Convertible arbitrage is a strategy that is employed by people in the finance world. In summary, convertible arbitrage, like other long-short strategies, may help increase returns in difficult market environments, but it isn’t without risks. The Limits of Convertible Bond Arbitrage 114 Insights into the Global Financial Crisis To minimize these risks, arbitrageurs generally go long a convertible bond and short the component parts of the bond (the straight debt and the equity option). Gil Song, portfolio manager at Man GLG, said large, unexpected moves in stocks that benefit convertible arbitrage investors may become more common. The fund’s increased liability on any outstanding short position would, in whole or in part, reduce this gain. Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds.It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock.. This paper specifies a simulated convertible bond arbitrage portfolio to characterise the risks in convertible bond arbitrage. To circumvent biases in reported hedge fund data, a simulated convertible bond arbitrage portfolio is constructed. Interest rate, credit and equity risks … Convertible arbitrage is a market-neutral investment strategy often employed by hedge funds.It involves the simultaneous purchase of convertible securities and the short sale of the same issuer's common stock.. Diversification is the simplest way to address call risk See also Agarwal, Fung, Loon, and Naik, “Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market,” working paper. The risks from investing in convertible bond arbitrage Convertible arbitrage strategy is pursued mainly by hedge funds and proprietary trading desks at investment banks, and is used to exploit inefficiencies in the pricing of convertible bonds by purchasing the undervalued security and hedging market risk using the underlying share. The returns from Convertible Arbitrage Zazove’s Convertible Arbitrage strategy seeks to provide bond-like returns with low volatility and low correlation to both fixed income and equity indices. As a result, investors considering a hedge fund that uses convertible arbitrage may want to carefully evaluate whether the potential return is balanced by the potential risks. The Limits of Convertible Bond Arbitrage: Evidence from the Recent Crash by Clifford Asness, Adam Berger, and Christopher Palazzolo ... To minimize these risks, arbitrageurs generally go long a convertible bond and short the component parts of the bond (the straight debt and the equity option). Convertible bond arbitrage: Get data on convertible bond prices and stock prices of the same companies and implement a backtest of the strategy. A model of convertible arbitrage strategies. It involves good timing and an understanding of future market conditions that could impact the trade. This paper specifies a simulated convertible bond arbitrage portfolio to characterise the risks in convertible bond arbitrage. The premise of the strategy is that the convertible is sometimes priced inefficiently relative to the underlying stock, for reasons that range from illiquidity to market psychology. 4. Convertible arbitrage is a tricky strategy. • The return premium for convertible arbitrage is compensation for liquidity risk and the risk that the value of a convertible bond fails to converge with Unpredictable things like credit and interest rate risks can put any potential profit in jeopardy. Managers must assess these risks and the most cost-effective way to manage them. Convertible arbitrage: risk, return and performance by Mark C. Hutchinson Abstract This study explores the risk and return characteristics of convertible arbitrage, a dynamic trading strategy employed by hedge funds. He started his banking career in the early 1990s and held roles as … During this same period, hedge funds have ... Convertible arbitrage is placed in this second group, along with 4 CONVERTIBLE ARBITRAGE 4076 P-01 5/30/03 3:22 PM Page 4. • Convertible bond buyers hope to earn a liquidity premium for holding an illiquid asset and providing financing for companies that would otherwise have difficulty borrowing. Convertible Arbitrage Risk: If the market price of the underlying common stock increases above the conversion price on a convertible security, the price of the convertible security will increase. Convertible arbitrage consists of buying a convertible bond and hedging two of the three factors in order to gain exposure to the third factor at a very attractive price. In summary, convertible arbitrage, like other long-short strategies, may help increase returns in difficult market environments, but it isn’t without risks. Convertible Bond Risks. In some instances stock options or an index of stocks, rather than the issuer's specific stock, is sold short to hedge the equity risk. The unique nature of convertible arbitrage trades has made them omewhat agnostic to rate rises. “Given recent estimates of retail participation in the market having doubled in the past two years alone, one might infer increased volatility is here to stay for at least some time,” said Song. For comparison the risk profile of convertible bond arbitrage hedge fund indices at both monthly and daily frequencies is also examined. 3. Convertible Arbitrage Returns This paper takes a similar approach to Liu and Longstaff (2004) and Mitchell and Pulvino Default occurs if the convertible bond issuer misses an interest payment or fails to return the principal balance. tion, and even new kinds of risks. They will also gain a firm understanding of alternative convertible structures, the use of foreign convertibles in hedging, risk management at the portfolio level, and trading and hedging risks. Like all bonds, convertible bonds are subject to default risk. Arbitrageurs can usually hedge the equity 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. Risk and Return in Convertible Arbitrage: Evidence from Convertible Bond Market At the turn of the century, capitalization of the global convertible bond (“CB”) market stood at just under $300 billion while the US equity market was more than 50 times higher at over $1.5 trillion.1 Yet during the difficult market conditions between Convertible Bond Arbitrage. More specifically, it is used by hedge funds. In order to capture the dynamic nature of hedge fund strategies, Fung and Hsieh (1997) put forward a model where a portfolio of hedge funds can be represented as a linear combination of a set of basic, synthetic hedge fund strategies. They will also gain a firm understanding of alternative convertible structures, the use of foreign convertibles in hedging, risk management at the portfolio level, and trading and hedging risks. A convertible bond can be transformed into a different form of security, which could be a common or preferred stock at a specific price in the future. Arbitrageurs can usually hedge the equity option component very easily by shorting Convertible Arbitrage Principal Risks: Convertible Securities Risk-The value of a convertible security is influenced by changes in interest rates, with investment value declining as interest rates increase and increasing as interest rates decline. Carry trade: Tremont Advisers, Inc. 555 Theodore Fremd Ave. Rye, New York 10580 T 914 925 1140 One thing to note about convertible bonds is that the timing of convertible arbitrage can be very complicated to pull off successfully. 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