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.

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RELATED FAQS
  1. What is a 'busted' convertible bond?

    Learn about busted convertible bonds; these are hybrid securities with conversion prices significantly higher than the market ... Read Answer >>
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    First, let's define convertible bonds. A unique combination of debt and equity, they provide investors with the chance to ... Read Answer >>
  3. Why would a corporation issue convertible bonds?

    Discover how corporations issue convertible bonds to take advantage of much lower interest rates as a result of a conversion ... Read Answer >>
  4. 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 >>
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