Definition of convertible bond arbitrage
The convertible bond arbitrage strategy aims to exploit mispricing in convertible bonds, by buying an undervalued convertible bond and taking a short position in the underlying equity. Arbitrageurs typically employ delta-neutral hedging, in which they short the stock according to the current delta of the bond.
When arbitrageurs buy the convertible bond, they set up an initial short position so that no profit or loss is generated from very small movements in the underlying stock price; profits are generated from the yield of the convertible bond and the interest rebate of the short position. After establishing the initial short position, arbitrageurs hedge dynamically to remain delta-neutral. In particular, if the underlying stock price increases, they short-sell more shares due to the increase in delta. If the stock price decreases, they buy back some shares to cover part of the short position because the delta has decreased.
Hedge funds are important players in the convertible bond market. In 2003, it was estimated that hedge funds bought 70 per cent of the primary issues.
Convertible bond arbitrage hedge funds buy convertible bonds, which are usually underpriced at issuance, and employ the arbitrage strategy to make profits. The Dow Jones Credit Suisse Convertible Arbitrage Hedge Fund Index is an asset-weighted index that tracks the performance of convertible bond arbitrage hedge funds.