Convertible Arbitrage
A relative-value strategy that buys convertible bonds and shorts the underlying equity to isolate the bond's volatility, credit, and rate components — earning carry, capturing volatility realization, and hedging delta dynamically.
Details
- aliases: Convert Arb
- category: relative-value
- investment thesis: Convertible bonds are structurally cheap to fair value because issuers price them to clear; the embedded option's volatility, rho, and carry can be extracted via dynamic hedging.
- edge source: Sophisticated option modeling, credit analysis of issuers, financing/borrow management, and gamma trading skill.
- typical holding period: 3 months to 3 years
- drawdown profile: Convex up, very negative skew. Catastrophic losses possible in liquidity crunches when both legs move adversely (2008).
- correlation to equities: 0.2
- correlation to bonds: 0.3
- liquidity profile: quarterly
- instruments used: convertible bonds, common stock, credit default swaps, stock-borrow
- asset classes: credit, equities, derivatives
- primary risks: liquidity crunches, credit-spread blowouts, stock-borrow recall, model risk on volatility
- key metrics: delta-hedged P&L, vega exposure, credit duration, implied vs realized vol
- notable practitioners: Citadel (early), Highbridge, Aristeia
- exemplar funds: citadel, aristeia
- related terms: convertible-bond, delta-hedging, gamma-trading, implied-volatility, credit-spread
- related strategies: volatility-arbitrage, credit-arbitrage
- academic foundations: Black-Scholes (1973), Merton (1974) credit model, Mitchell, Pedersen, Pulvino — Slow-Moving Capital (2007)