Legal Definitions - convertible arbitrage

Convertible arbitrage is a sophisticated investment strategy where an investor simultaneously buys a convertible security (such as a convertible bond or convertible preferred stock) and sells short the underlying common stock of the same company. The primary objective is to profit from perceived pricing discrepancies or inefficiencies between the convertible security and its underlying stock, while also attempting to minimize overall market risk through this hedged position. Investors aim to capture the fixed-income benefits of the convertible security (like interest payments) while hedging against potential declines in the stock price.

• Example 1: Corporate Bond Mispricing

  An investment firm identifies that "Tech Innovations Inc." has issued convertible bonds. After detailed analysis, the firm believes these bonds are slightly undervalued compared to Tech Innovations' common stock, which appears somewhat overvalued in the market. To execute a convertible arbitrage strategy, the firm purchases a substantial amount of Tech Innovations' convertible bonds. Simultaneously, they short-sell an equivalent value of Tech Innovations' common stock. The firm aims to profit from the bond's fixed interest payments and any potential appreciation if the bond price corrects upwards. The short position in the stock acts as a hedge, protecting against a general market downturn or a specific drop in Tech Innovations' stock price. If the stock falls, the profit from the short sale would offset potential losses on the convertible bond, and vice versa, allowing the firm to capture the mispricing or the bond's yield with reduced market exposure.

• Example 2: Volatility Discrepancy in Preferred Stock

  A hedge fund specializing in arbitrage observes that "Green Energy Solutions" has convertible preferred stock trading on the market. The fund's analysts notice that the implied volatility (the market's expectation of future stock price fluctuations) embedded in the convertible preferred stock's price is significantly lower than the historical volatility of Green Energy Solutions' common stock. This suggests a potential mispricing. The fund decides to buy the convertible preferred stock and simultaneously short-sell an appropriate amount of Green Energy Solutions' common stock. Their strategy is to profit from the expected convergence of implied and historical volatility, or from the fixed dividend payments of the preferred stock, while the short position in the common stock hedges against adverse movements in the equity market. This allows them to capitalize on the perceived undervaluation of the volatility component within the convertible preferred stock.

• Example 3: Event-Driven Arbitrage

  Following a major acquisition announcement by "Global Conglomerate Corp.," the company issues new convertible bonds to finance the deal. An arbitrageur believes that the market has not fully priced in the positive long-term implications of the acquisition for the common stock, but also sees that the convertible bonds offer an attractive yield. The arbitrageur buys these newly issued convertible bonds for their income stream and potential upside from the acquisition. To mitigate the risk of short-term market volatility or a temporary dip in the stock price post-announcement, they simultaneously short-sell a calculated amount of Global Conglomerate Corp.'s common stock. This strategy allows them to collect the bond's interest payments and potentially benefit from the long-term appreciation of the underlying company, while the short position provides a hedge against immediate market fluctuations or unforeseen negative news related to the acquisition.