Convertible arbitrage is a trading strategy that typically involves taking a long position in a convertible security and a short position in the underlying common stock, to capitalize on pricing inefficiencies between the convertible and the stock. Convertible arbitrage is a long-short strategy that hedge funds and big traders favor.
Breaking Down Convertible Arbitrage
The rationale behind a convertible arbitrage strategy is that the long-short position enables gains to be made with a 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 the gain on the convertible would offset it. 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 a 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 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.