Convertible arbitrage

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Convertible arbitrage: This is a strategy popular among hedge funds that operates by purchasing convertible securities, typically convertible bonds, and selling short the underlying common stock to hedge the equity risk of the convertible bond. The profit lies in seeking out convertible bonds that are mispriced relative to the common stock. Convertible arbitrage is especially profitable in times of high volatility for the common stock, as the convertible bond market is much more illiquid, giving rise to mispricings and other exploitable inefficiencies. Managers may choose to hedge some or all of the equity risk of a convertible bond. A convertible bond is a security issued by a company which may be converted from debt to equity, and vice-versa, during various points in the life cycle of the security. Managers may choose to hedge some or all of the equity risk of a convertible bond. Even if an arbitrageur hedges the entire equity portion, that does not remove all risk, but it does substantially reduce the risk of holding the bond. As a form of debt, the convertible bond is also fairly high in the order of payment, below the pure bondholders, but higher than the holders of common stock.

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