You buy a convertible bond, short the stock and the books says that the risks are:
I get number 2 and 3, but why is number 1 a risk when the stock is hedged through the short position? Do they mean that if the stock price falls, perhaps due to worse business outlook, usually the convertible bond’s price also would fall?
Good question … i’d have thought there’s risk of a sudden high dividend on the short position but not outright price risk on the underlying.
When a stock decline, the convertible decline more due to liquidity reasons, eg. During economic crisis. So the underlying price is a risk.
This is what I think.
How can arbitrage have risk?
I didn’t see the risk mentioned in the Kaplan book. But they do mention that " the strategy would benefit if stock volatility increases (2) and the convertible rises in value (1).
So, based on Kaplan, sounds like the first two points are benefits if either or both values go up. I guess they they could be risks if they do down.
Risk generally means uncertainty of any sort that affects the investment; it doesn’t have to affect it negatively.
Good point. A big misleading name on this strategy…