Convertible Arbitrage is a strategy that hedge funds use to make consistent returns while experiencing minimal volatility regardless of market direction.
On a basic level, this strategy involves selling short an overpriced stock and using the proceeds to buy the same issuer’s underpriced convertible bond. To keep things simple, let us assume the number of stocks that are sold short and the number of stocks the convertible bond can be converted to is the same. By doing this, we are hedging ourselves completely against equity risk.
So if equity prices rise in a falling interest rate environment, we make a loss on our short position (stock) which is offset by a gain on our long position (convertible bond). Vice versa, when equity prices fall in a rising interest rate environment, we make a loss on our long position (convertible bond) which is offset by a gain we make on our short position (stock). All the while, we are earning interest payments from the bond, and interest from investing any extra proceeds from the initial short sale.
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Canadian Securities Course textbook volume 2