Convertible Arbitrage

DEFINITION of 'Convertible Arbitrage'

A trading strategy that typically involves taking a long strategy in a convertible security and a short position in the underlying common stock, in order to capitalize on pricing inefficiencies between the convertible and the stock. Convertible arbitrage is a long-short strategy that is favored by hedge funds and big traders.

BREAKING DOWN 'Convertible Arbitrage'

The rationale behind a convertible arbitrage strategy is that the long-short position enables gains to be made with a relatively lower degree of risk. If the stock declines, the arbitrage trader will benefit from the short position in the stock, while the convertible bond or debenture will have less downside risk because it is a fixed-income instrument. If the stock gains, the loss on the short stock position would be capped because it would be offset by the gain on the convertible. If the stock trades sideways, the convertible bond or debenture pays a steady coupon that may offset any costs of holding the short stock position.

As an example of convertible arbitrage, consider a stock that is trading at $10.10. It also has a convertible issue with face value of $100, convertible into 10 shares at a conversion price of $10; the security continues to trade at par ($100). Assuming there are no barriers to conversion, an arbitrageur would buy the convertible and simultaneously short the stock, for risk-less profits (excluding transaction costs) of $1 per $100 face value of the convertible. This is because the arbitrageur receives $10.10 for each share sold short, and can cover the short position right away by converting the convertible security into 10 shares at $10 each. Thus total gain per $100 face value of the convertible is: ($10.10 – $10.00) x 10 shares = $1. This may not sound like much, but a 1% risk-less profit on $100 million amounts to $1 million.

This situation is quite rare in the present-day world, where algorithmic and program trading has proliferated to sniff out such arbitrage opportunities. In the above example, the downward pressure on the stock caused by short-selling, and the upward pressure on the convertible from arbitrage buying, would very rapidly eliminate any pricing discrepancies.

In addition, since a convertible can be viewed as a combination of a bond and a call option, the convertible issue in the earlier example would likely be trading well above its intrinsic value, which is the number of shares received upon conversion times the current stock price, or $101 in this case.

A convertible arbitrage strategy is not bullet-proof. In some instances, it may go awry if the convertible security declines in price but the underlying stock rises.

RELATED TERMS
  1. Convertible Bond Arbitrage

    An arbitrage strategy that aims to capitalize on mispricing between ...
  2. Convertible Security

    An investment that can be changed into another form. The most ...
  3. Convertibles

    Securities, usually bonds or preferred shares, that can be converted ...
  4. Convertible Hedge

    A trading strategy that consists of a long position in a company's ...
  5. Conversion Price

    The price per share at which a convertible security, such as ...
  6. Conversion Parity Price

    The price paid for a share of stock purchased by exercising the ...
Related Articles
  1. Investing

    Why Include Convertible Securities in Your Portfolio

    What are convertible securities and why you should include them in your portfolio.
  2. Financial Advisors

    Worried About Stocks? Try on Convertibles

    Convertibles are a good hedge against equity market risk (if you're o.k. with losing a bit of upside potential).
  3. Bonds & Fixed Income

    The Wonders Of Convertible Bonds

    Ever wondered what exactly a convertible bond does? Read the features of a convertible bond and learn how important the conversion factor is to you as an investor.
  4. Bonds & Fixed Income

    Convertible Bonds: An Introduction

    Find out about the nuts and bolts, pros and cons of investing in bonds.
  5. Mutual Funds & ETFs

    3 Best High-Yielding Convertible Bond ETFs (CWB, ICVT)

    Discover how convertible bond ETFs can offer investors growth and income while hedging fixed income portfolios in a rising rate environment.
  6. Stock Analysis

    Convertible Securities In Today's Market

    John Calamos, the father of convertible investing, moderated a panel on convertible bonds at the Milken Global Conference April 27.
  7. Stock Analysis

    A Convertible Income Choice

    Given the low interest rate environment, convertible bonds is one way for income investors to find yields.
  8. Investing

    What You Should Know About Convertible Bonds

    As investors continue to seek yield in the current market, it's now a good time to bring up an often overlooked asset class—the convertible bond.
  9. Bonds & Fixed Income

    Leverage Your Returns With A Convertible Hedge

    Find out how you can maintain your income stream by using this type of bond strategy.
  10. Bonds & Fixed Income

    The Top 6 Convertible Bond Funds for 2016

    Take a look at convertible bond mutual funds that are well-positioned heading into 2016, and why investors might consider a convertible fund portfolio.
RELATED FAQS
  1. What is a Chinese hedge?

    A Chinese Hedge is a form of arbitrage by which an investor shorts a convertible bond and buys the underlying common stock. ... Read Answer >>
  2. 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 Answer >>
  3. How do I use a premium put convertible?

    Holders of convertible bonds face all the pitfalls that traditional bondholders face - liquidity risk, interest rate risk ... Read Answer >>
  4. What is a convertible bond?

    A convertible bond is a bond issued by a corporation that, unlike a regular bond, gives the bondholder the option to trade ... Read Answer >>
  5. How is convertible bond valuation different than traditional bond valuation?

    Read about bond valuation, particularly the differences between how a traditional bond is valued and how a convertible bond ... Read Answer >>
  6. Why do some investors prefer convertible over “straight” bonds?

Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center