In this article we will be looking at the term convertible arbitrage and how it is used in the hedge fund industry. We will also be looking at why it is important. At first, the term itself may seem daunting and many people will think that there is a complex procedure behind it. Indeed one does require a brief introduction and background regarding it before they can fully understand the term, but just like in the case of other financial jargon, this too can be defined in a simple and easy to understand way.
What is Convertible arbitrage
Convertible arbitrage is a strategy that is employed by people in the finance world. More specifically, it is used by hedge funds. Basically, convertible arbitrage is a market related activity which helps hedge funds to perform better which is something that all the investors as well as the fund manager want. It is a market neutral strategy, which in simpler language means any strategy that helps to steer clear of any risks that come with being in the market. Usually, the way this is accomplished is through hedging, a term that in itself originates because of the same desire of avoiding risk.
Convertible arbitrage works by employing two different approaches at the same time. One of these is to buy convertible securities and the other is the short sale of common stock. The previous statement cannot be understood if one does not know the definition of the two key words. Therefore, we will proceed to define what is meant by convertible securities and common stock. A convertible security is a special kind of security which can be easily converted or switched into some other kind of security. There are two main kinds of convertible securities. One of these is known as convertible bonds while the other is referred to as preferred stocks. These preferred stocks can further be traded into common stock shares.
At this point, it would be worthwhile to define the term common stock so that the relationship between all these financial components can be understood. In certain regions, common stocks are also known as voting share or ordinary share. Common stock is that particular equity ownership that more often than not comes with the right to vote matters. For instance, someone who purchases these might be allowed to cast a vote to voice their opinion regarding who should be allowed to be a member of the board of directors of a company.
The logic behind the strategy of convertible arbitrage is that the prices of these are usually not accurately determined and thus they can often be faulty and efficient. Common stocks on the other hand are relatively much more efficiently priced than these convertible securities are. Why this happens to be the case is another topic of discussion, since there can be many different reasons leading up to this and each of them need individual explanations.
The essence of convertible arbitrage is in locating and spotting exactly those convertible securities that have been incorrectly priced in relativity to the underlying common stock. Generally speaking, the higher the volatility of the common stock, the higher will be the profit margin from making use of convertible arbitrage as a strategy.
Initially, there were few players in the market who used convertible arbitrage to their advantage, but slowly, over the past few decades, this number has risen dramatically. This has one main implication for the strategy in the financial arena of hedge funds today. Since a larger set of people are now aware of the benefits that they stand to gain from going down this route, the competition too has increased just as significantly. Hence, as a result, the overall usefulness of employing convertible arbitrage has decreased as it is no longer as exclusive as it used to be.
Nonetheless, it continues to be a commonly used tool, which still has its positives that have enabled it to maintain its existence in the industry today.