Alternative Investments - convertible arbitrage

CFA Level III Portfolio Management
#1

Good evening everyone, and Happy New Year!

Convertible bond arbitrage: involves profiting from mispricings between the bond and the underlying stock (investor has a long call option on the stock). I would have 2 questions:

  1. Investment wants to access the relatively cheap embedded optionality. Does this “cheap” optionality mean that the stock is undervalued re the bond, so being long the stock allows you to profit when the stock goes up?

  2. Does this strategy also work by being short the stock? (if the stock is overvalued) In this case, you cannot profit from the “cheap” optionality anymore…

Many thanks!

#2

I cannot really wrap my head around this one, because this is how I understood it: you have a l ong call option re the stock.

  1. stock price declines (call is out of money): do not exercise the option
  2. stock price increases (call is in the money): exercise option, convert bond into shares (capital appreciation)

However, according to Investopedia and other online sources, are two ways this arbitrage can be implemented:

if the convertible bond is cheap or undervalued relative to the underlying stock: buy/long the undervalued convertible bond and take a short position in the overvalued underlying stock

  • stock price falls in value: arbitrageur will profit from its short position - HOW CAN YOU SHORT SHARES IF YOU HAVE NOT DONE THE CONVERSION YET?
  • if stock prices rise instead: bonds can be converted into stock which will be sold at the market value, resulting in a profit from the long position

if the convertible bond is overpriced relative to the underlying stock: take a short position in the convertible bond and a long position in the underlying stock

  • If share prices increase, the gains from the long position should exceed the loss from the short position
  • If stock prices decrease instead, the loss from the long in the equity is less than the gain from the price of the convertible bond GAIN IN PRICE OF THE CONVERTIBLE BOND - DOES THIS MEAN YOU ARE SELLING YOUR CONVERTING BOND?

This is really confusing :frowning: can someone pls help?

Thanks a lot!

#3

Why are you confused ? You are mixing too many concepts in one without understanding their relationship and hierarchy . That is all. Let us try and untangle this step by step:

  1. Convertible bond arbitrage - you know all the elements involved. Basically 3. The issue( bond), the underlying security ( stock) and the. Convertibility option. But natural, one would exercise the option when one sees the profit in it. So the natural position in this set up is a long one.( It could be short as well but we will delve that a little later). Remember whatever is applicable for a convertible bond is equally applicable to convertible pref shares and warrants and any other convertible instruments.

  2. Now let us also decipher a few more agents to this set up. The risk free rate, the volatility of the underlying stock resulting in the volatility of options and from the level 2 of the CFA curriculum you know that volatility is a friend of option ( call/put), the time over which the vesting may happen ( a bond has a stipulated time before maturity and since a call option is involved here this time to maturity at the most will lend to the time to expiry of the convertibility of option.), Stock price current and projected over the horizon, associated free float options of the stock if any being traded in the market, dividend if any of the stock, the Bond’s coupon and the bond’s current rating and possible rating migration over the horizon.

  3. From basic accounts and capital structure we know that this convertible instruments will seat above the common equity.

  4. With the above in place, let us now imagine a few scenarios :

A. The bond improves in rating or it’s yield decreases. The valuable bond now will automatically lend itself to the underlying security

B. The bond deteriorates and thus the underlying security also deteriorates

C. Either the bond appreciates or depreciates but does not have the DESIRED impact on the underlying stock ( resulting in relative price movement mismatch)

D. There is a actually a mismatch and mispricing existing between the two

Hmmmm…now as a hedge fund manager, I need an insurance to this otherwise profitable but complex set up.

So, if I am long this set up ( long the convertible bond), I short sell the underlying stock. Keep the cash proceeds in the risk free rate or any other suitable opportunity cost bearing investment but with assured returns only.

With the above, and among the 4 scenarios whichever and whatever happens I covered and in a perfect world will end up earning risk free rate…PL. take some time in and think through. It should be clear.

With mis pricing , I will always buy cheap and sell high. So in other scenarios , I shall buy the stock and short the bond - if they are inherently overpriced.

Remember , here convertibility is 1 bond = x no. of shares.

Revert if you still have issues.

#4

Dear Herb,

Thank you very much for taking the time to explain this in such detail! Great!!

I know understand it - it can go both ways - long the bond, short the underlying stock, or long the underlying stock, short the bond. So, “profiting from the cheap embedded optionality” is not only in the first case from my initial comment, but in both.

If I may ask you 2 more things, from my second comment above:

buy/long the undervalued convertible bond and take a short position in the overvalued underlying stock

  • stock price falls in value: arbitrageur will profit from its short position - CAN YOU SHORT SHARES IF YOU HAVE NOT DONE THE CONVERSION YET?

short position in the convertible bond and a long position in the underlying stock

  • If stock prices decrease instead, the loss from the long in the equity is less than the gain from the price of the convertible bond GAIN IN PRICE OF THE CONVERTIBLE BOND - DOES THIS MEAN YOU ARE SELLING YOUR CONVERTING BOND? Yes, that is what a short position is, but I am not sure in this context it means selling your bond…

Thanks again,

Regards,

C.

#5

Ans to 1:

Yes. You could short sell the open shares from the market even before you convert. Conversion here is a mere exercising of a call option . In this case your short position will fetch you instant cash . The non of shares shorted can then be returned after the tenure through conversion of the bond instrument.

Ans to 2:

Yes. You could short sell the bond that is convertible and hope that it stays that way. Just remember if the buyer of this convertible bond has his fortune turned in favour, his bond would appreciate and he would definitely convert it to shares. Your long position will hedge that.

#6

Thank you, Herb, all the best for 2020!