DEFINITION of 'Convertible Arbitrage'

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, in order 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 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 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. Busted Convertible Security

    A busted convertible security is a convertible bond where the ...
  2. Convertible Bond

    A convertible bond is a bond that can be converted into a predetermined ...
  3. Dividend Enhanced Convertible Stock ...

    Dividend Enhanced Convertible Stock is a preferred stock that ...
  4. Premium Adjustable Convertible ...

    A premium Adjustable Convertible Security - PEACS combines a ...
  5. Yield Advantage

    Yield advantage is the additional yield an investor can earn ...
  6. Set-Up Hedge

    A set-up hedge is a investing strategy which sets a convertible ...
Related Articles
  1. Investing

    An Introduction to Convertible Bonds

    Getting caught up in all the details and intricacies of convertible bonds can make them appear more complex than they really are.
  2. Investing

    Convertible bonds: pros and cons for companies and investors

    Understand what effect convertible bonds have on investors and companies. Find out the advantages, disadvantages, and what the issue means from a corporate standpoint before buying in.
  3. Investing

    Introduction to Convertible Preferred Shares

    These securities offer an answer for investors who want the profit potential of stocks but not the risk.
  4. Investing

    Can a Bond ETF Work in a Rising Rate Environment?

    The CWB Convertible Securities ETF could be the perfect solution for a rising rate environment.
  5. Managing Wealth

    The Mandatory Convertible: A "Must Have" For Your Portfolio?

    Mandatory convertibles are a little understood security with some distinct advantages. Find out if they are right for you.
  6. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  7. Investing

    How Precious Metals Like Gold Can Be Arbitraged

    Arbitrage trading involves a lot of risk and can get challenging. Find out how to benefit from the price differential between the buy and sell price.
  8. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for merger and acquisition or other corporate actions eligible stocks.
  9. Investing

    The multiple strategies of hedge funds

    Current and potential hedge fund investors need to understand how much risk hedge funds take on in order to make money.
RELATED FAQS
  1. Where Does Stock From Convertible Bonds Come From?

    Convertible bonds are considered a combination of debt and equity. Find out how a debt instrument converts into shares of ... Read Answer >>
  2. Do convertible bonds have voting rights?

    Convertible bonds usually have no voting rights until they are converted. Even after conversion, they may not be granted ... 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. Can Private Corporations Issue Convertible Bonds?

    Find out why a "private corporation" isn't suited to issue convertible bonds. Determine what prevents this move into a company's ... Read Answer >>
  5. What is stock dilution?

    Stock dilution occurs when company actions reduce the ownership percentage of current shareholders. Find out how ownership ... Read Answer >>
Trading Center