What does this mean?
convertible bonds arbitrage strategy “strive to extract “underpriced” implied volatility from long convertible bond holdings” ???
Can anyone explain this to me please?
Basically when you go long the convertible bond you’re actually long the call option on the stock. And options run on volatility. So by going long the conv bond you’re indirectly long the volatility. They call it underpriced as the strategy involves going short the stock and long the bond which is like an underpriced version of the stock due to the embedded call in it. Hope this helps.
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Hi Saurabh,
Thanks for your response. I understand the part that we buy CB and short the stock. CB has a call option which has volatility. But I lost you after that especially this line-
“which is like an underpriced version of the stock due to the embedded call in it.”
Could you please explain that to me?
Thanks,
They’re saying the embedded call option is undervalued by virtue of having lower volatility relative to a standalone call option so by buying the CB you’re getting an underpriced option as far as Vega is concerned.
I meant buying the bond is similar to buying an underpriced stock due to the embedded call in it.
As is common, their language complicates something that’s pretty simple.
First, think of implied volatility as a proxy for price; if the implied volatility is too:
- high, the option is overpriced
- low, the option is underpriced
So . . . what they’re saying is that in convertible bond arbitrage, you should buy bonds whose conversion option is underpriced. (Then, you essentially strip out the conversion option (hedging everything else) and sell it for a fair price, making gobs of money in the process.)
Oh I see… as usual, thanks magician for the explanation.
My pleasure.