Convertible Bond Arbitrage

DEFINITION of 'Convertible Bond Arbitrage'

An arbitrage strategy that aims to capitalize on mispricing between a convertible bond and its underlying stock. The strategy is generally market neutral; in other words, the arbitrageur seeks to generate consistent returns with minimal volatility regardless of market direction through a combination of long and short positions in the convertible bond and underlying stock.

BREAKING DOWN 'Convertible Bond Arbitrage'

If the convertible bond is cheap or undervalued relative to the underlying stock, the arbitrageur will take a long position in the convertible bond and a simultaneous short position in the stock. Conversely, if the convertible bond is overpriced relative to the underlying stock, the arbitrageur will take a short position in the convertible bond and a simultaneous long position in the underlying stock.

The price of a convertible bond is especially sensitive to changes in interest rates, the price of the underlying stock, and the issuer's credit rating. Therefore, another type of convertible bond arbitrage involves buying a convertible bond and hedging two of the three factors so as to get exposure to the third factor at an attractive price.

RELATED TERMS
  1. Credit Rating

    An assessment of the creditworthiness of a borrower in general ...
  2. Municipal Bond Arbitrage

    A strategy that consists of building a portfolio of tax-exempt ...
  3. Maintenance Bond

    A type of surety bond purchased by a contractor that protects ...
  4. Convertible Bond

    A bond that can be converted into a predetermined amount of the ...
  5. Conversion Price

    The price per share at which a convertible security, such as ...
  6. Busted Convertible Security

    A convertible security that is trading well below its conversion ...
Related Articles
  1. Bonds & Fixed Income

    Convertible Bonds: Pros And Cons For Companies And Investors

    Find out why businesses choose this type of financing and what effect this has on investors.
  2. Bonds & Fixed Income

    Convertible Bonds: An Introduction

    Find out about the nuts and bolts, pros and cons of investing in bonds.
  3. Investing Basics

    NYIF Instructor Series: Risk Arbitrage

    In this short instructional video Jack Farmer explains what risk arbitrage is outlines three different examples of it.
  4. Investing

    A New Reason Behind This Strategy’s Outperformance

    One of the great anomalies of investing: The historical long-term outperformance of smart beta or factor-based strategies relative to the equity market.
  5. Trading Strategies

    Why Short Sales Are Not For Sissies

    Short selling has a number of risks that make it highly unsuitable for the novice investor.
  6. Mutual Funds & ETFs

    Protect Mutual Funds From a Volatile Market

    Learn about the best ways to invest in mutual funds, including which types of funds are safest, while still protecting your investment from market volatility.
  7. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  8. Active Trading Fundamentals

    Arbitrage Pricing Theory: It's Not Just Fancy Math

    What are the main ideas behind arbitrage pricing theory? We provide a simple explanation of the model and how to use it.
  9. Investing Basics

    Understanding Arbitrage Pricing Theory

    Investors use the arbitrage pricing theory to identify an asset that’s incorrectly priced.
  10. Trading Systems & Software

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
RELATED FAQS
  1. Where does the stock come from when convertible bonds are converted to stock?

    First, let's define convertible bonds. A unique combination of debt and equity, they provide investors with the chance to ... Read Full Answer >>
  2. What is the difference between convertible and reverse convertible bonds?

    The difference between a regular convertible bond and a reverse convertible bond is the options attached to the bond. While ... Read Full Answer >>
  3. What is arbitrage?

    Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. ... Read Full Answer >>
  4. Is there a difference between financial spread betting and arbitrage? (AAPL, NFLX)

    Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >>
  5. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  6. How does arbitrage affect the price of exchange traded funds (ETFs)?

    Arbitrage may be used to bring the market value of an exchange-traded fund (ETF) back into line with the net asset value ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center