Convertible Arbitrage

When it comes to producing profits from the stock market, there are numerous techniques to choose from. Apart from the well-known technical and fundamental methods, investors should be aware of another type of strategy called Arbitrage.

These tactics are mostly used by large institutional investors, such as hedge funds, and are excellent low-risk ways to create returns. Here's what you should know about convertible bond arbitrage if you're curious.

What is a Convertible Arbitrage Strategy?

Convertible arbitrage definition:

Convertible bond arbitrage is an arbitrage strategy that seeks to profit from mispriced convertible bonds and their underlying stocks.

The strategy is largely market agnostic. In other words, the arbitrageur uses a combination of long and short positions in the convertible bond and underlying stock to achieve steady profits with little volatility regardless of market direction.

How Does Convertible Arbitrage Work?

One of three outcomes is likely to occur after a convertible arbitrage approach is implemented. Let's take a look at each case one by one to see how convertible Arbitrage works.

Case 1:

Short positions in the company's stock would begin to profit in this situation. The Price of the convertible bond would fall at the same time. However, because it is a fixed-income product, the impact of a price drop is expected to be limited. The reward you receive will be the difference between the gains from the short position and the reduction in the price of the convertible bond.

Case 2:-

Short positions in the company's stock would begin to lose money at this point. The increase in prices of the convertible bond, on the other hand, would mitigate the loss. Convertible Arbitrage provides little protection against losses resulting from price increases in the asset.

Case 3:

Even if the stock price remains unchanged, the convertible bond will continue to produce profits through monthly interest payments. These profits can then be used to offset the costs of holding a short position in the company's stock. You'd very certainly find up in a no-profit, no-loss situation.

Importance of Convertible Arbitrage

The justification for using a convertible arbitrage strategy is that taking a long-short position increases the likelihood of profit while reducing risk. As it is equity and matter flows in the direction of the market, the arbitrage trader will benefit from the short position in stock if the stock's value falls. The convertible bond or Debentures, on the other hand, will have fewer risks because it is a fixed-rate product.

If the stock rises, however, the loss on the short stock position will be limited since the earnings from the convertible security would compensate for it. If the stock remains at par and does not rise or fall, the convertible security or debenture will continue to pay a consistent coupon rate, which will cover the costs of holding the short stock.

Another reason for using a convertible arbitrage is that a company's convertible bonds are inefficiently priced in comparison to its shares. This could be because the company is attempting to entice investors to invest in its debt stock by offering attractive rates. This pricing inaccuracy is exploited by Arbitrage.

Risks of Convertible Arbitrage

Convertible Arbitrage is more difficult than it appears. As convertible bonds must generally be held for a set period of time before being converted into equity stock - it is crucial for the arbitrageur/fund manager to carefully assess the market and determine whether market conditions or other macroeconomic factors will have an impact during the conversion period.

Convertible Arbitrage Example

We'll overlook transaction and conversion charges for now. We'll also suppose that each warrant is convertible into one share. Consider the following scenario for a firm ABC:

Share Price = 6

Exercise Price = 10

Warrant Price = 3

We'll buy 100 ABC common shares and sell 100 ABC warrants, with the goal of turning both positions into cash before the expiration date.

The warrant will only be worth little if the common share price is at or below the exercise price. Otherwise, the warrant will be worth around ten rupees less than the stock price.

If the stock price rises to 20, the warrant will be worth around 10. As a result - we should profit 20–6 = 14 from the increase in stock price while losing 10–3 = 7 from the increase in warrant value. This results in a 700 profit.

The warrant will sell for a few rupees if the stock price stays between 10–6. As a result, the warrant buyer will not execute, but we will still profit 3 per share on the short sell.

We will lose the amount below six if the common falls below 6. Unless the common falls below 3 - these losses will more than balance our short-sale profits, leaving us in the black.

If the stock price goes to zero, we will only have lost 300. Since this is significantly less than the potential profit of 700, the chances of success are higher.

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