Convertible ArbitrageHedge Funds
Convertible Arbitrage exploits price differences among assets which can be converted into other investment instruments. These instruments maintain the same source of underlying value, usually the issuing firm. Convertible arbitrage usually consists of convertible bonds or preferred shares, which can be converted to common shares. Arbitrage requires knowing the conversion ratio, the convertible asset’s price, and the price per common share. The price of purchasing convertible assets and changing them into common shares must be cheaper on a per share basis than open market purchases of those shares. If this is true, the convertible asset is undervalued compared to the common shares. If the convertible asset is undervalued, arbitrage strategies are viable. It is fairly easy to see pricing inefficiencies in the market, and capitalize on their differences. Most plays purchase the convertible asset, and short sell the common shares to seize profit from converging prices.
The manager’s alpha is centered on their ability to assess the risk versus return of convertible arbitrage accurately, and the financial situation of the underlying firm. Manager profit from convertible arbitrage is determined by the difference between the convertible’s current market values and the reward provided by conversion. Trading convertible bonds based on anticipated interest rate changes and their effects on bond prices can help funds boost returns.
Managers must capitalize on trades that generate value for the fund, knowing and avoiding the landmines which could result in poor conversions. When activating short sales, the manager must remain aware of any reason the prices could sink or remain in place, and any dividends that must be paid. If the price remains stale, the short sale will generate no profits, and if the price on the short side rises it will generate a loss. If dividends are paid to the manager during the short, they must compensate the people who loaned the sold shares for their missed dividends.
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