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# How Convertible Bond Arbitrage Works II

## Posted By FrugalTrader On September 27, 2007 @ 5:00 am In Stock Investing | 22 Comments

Yesterday, Preet Banerjee from WhereDoesAllMyMoneyGo.com [1] explained the basics behind
convertible bonds [2]. Today he will continue to explain how convertible bond arbitrage works
along with some case studies.
Okay, so yesterday we explained the CONCEPT of convertible bonds [2]. Let’s quickly define
Arbitrage:
Arbitrage
Arbitrage is when you are long and short two related securities (or the same security in some
cases) in order to make a gain when the price changes. I realize that it sounds counterintuitive –
the best way to explain is to show an example. Hmmm… I wish I had a security that lends (no
pun intended!) itself well to arbitrage… Hold the phone! I do: The Convertible Bond!!!! Let’s
take a look:
Convertible Bond Arbitrage
Like I said the best way for me to explain is to dive right in with an example – and then you can
work backwards to make sure it makes sense.
Let’s start out with our convertible bond at issue time. It is being issued at \$1000, with a coupon
payment of 5% and let’s say that it is a 2 year bond (not common, but for the sake of the
example). It has a conversion rate of 50:1 – so you can exercise your conversion privilege
anytime and receive 50 shares of the underlying common stock. Right now the share price is \$20.
To engage in Convertible Bond Arbitrage you have to buy and sell (at the same time) two related
securities – and in this case you are buying the convertible bond for \$1000 and at the same time
you are shorting 25 shares of the common stock – you’ll note that you are shorting HALF the
amount of shares that the bond could be converted to, which is 50. (If you are not familiar with
shorting – stop now and look it up – then come right back here.) Now we will look at three cases:
1) No change in the share price for 1 year. 2) Share price goes up after 1 year. And 3) Share price
goes down after 1 year. In all three cases you MAKE a gain (all else being equal).
Case 1: Share price does not change for the year
You have received \$50 in interest for the year (coupon payments on the bond). You have also
received interest on the proceeds of the short sale for one year (when you short a stock you are
selling it which means you have cash on hand that you can gain interest on – we’ll say your
brokerage account pays 2% on cash balances). Since you “sold” 25 shares at \$20 you have \$500
earning the 2% interest – which equals \$10. There is also the interest you have to pay for
borrowing the shares from your broker to sell – let’s say this is 1% – so you have a COST of \$5
to borrow the shares you shorted. Your running total so far is \$55 in your pocket.
Now, remember nothing has happened to the share price, so your convertible bond is still worth
\$1000. At day 366, you cover your short and you sell your convertible bond. In other words you
have completely unwound the strategy.
So at the end of the day you earned 5.5% for the year (Interest on the bond plus the interest on
the short sale proceeds less the cost of borrowing the shorted stock). Not bad for 5% bond, right?
Case 2: Share price rises to \$25 after 1 year.
50 Shares at \$25 is worth \$1250 – so your convertible bond has made you money (\$250 gain).
You have to subtract your loss on your short position (you lose money if a shorted stock goes up
in value). In this case, when you unwind your short you have essentially sold it for \$20 at the
beginning and bought it back for \$25 when you cover your position at the end of the year.
Therefore you have a loss of \$5 per share (\$20 Shorting price less \$25 Covering price) which for
25 Shares equals a \$125 loss on your short position. We still have the interest on the proceeds of
the short position (\$10) and the interest charged to borrow the stock from your broker to
establish a short position (-\$5). This leaves you with \$250 (Capital Gain on the convertible bond)
+ \$50 (Interest earned on the bond) – \$125 (Loss on the short) + \$10 (Interest earned on the
proceeds of the short sale) – \$5 (Interest charged on the borrowed securities for the short) = \$180
at the end of the year.
So in this case you have earned 18.0% for the year because the share price went up.
Case 3: Share price decreases to \$15 after 1 year
Okay, so your convertible bond is worth \$750 since 50 shares x \$15 = \$750? WRONG –
Remember – the value of the convertible bond won’t fall below it’s intrinsic value – or what it
would trade like if were just a bond. So in this case it is still worth \$1000. You are break even on
the bond. BUT you have made money on your short position. Since the stock has gone down in
value you have effectively sold it at \$20 and bought it for \$15 when you cover your short
position for a gain of \$5 per share. Multiply that by 25 shares are you have a gain of \$125 on
your short sale. We still have the same interest on the short sale proceeds for the year of \$10 and
a cost of interest on the borrowed securities from your broker of \$5. Add all that up and we have
\$0 + \$125 + \$10 – \$5 = \$130.
So in this case you have earned 13% for the year because the share price went down.
The End – Now don’t go out there and do it
This concludes my guest article on Convertible Bond Arbitrage – I would suggest not rushing
out and immediately implementing this strategy just yet – do a LOT more research – because the
conversion rates can be complex formulas for convertible bonds and you need to examine the
effects of each of the three scenarios I just went through with the conversion math of the
convertible bond issue you are looking at. I made up a fictitious convertible bond example with
an accompanying fictitious stock example.
If you found this article of interest – please take a look at my own blog and consider signing up
for my RSS feed there: WhereDoesAllMyMoneyGo.com [1]
blogger like myself to receive such a request!

URL to article: http://www.milliondollarjourney.com/how-convertible-bond-arbitrage-works-
ii.htm
URLs in this post:
[1] WhereDoesAllMyMoneyGo.com: http://www.WhereDoesAllMyMoneyGo.com
[2] basics behind convertible bonds: http://www.milliondollarjourney.com/how-convertible-
bond-arbitrage-works-i.htm

## 14. Joe Lavely

The cases contain several erroneous assumptions. I will focus on only one.
In Case 3, there is a statement that, if the stock price falls, the price of the convertible bond [CB]
remains constant at \$1,000 because that remains the intrinsic value of the bond portion of the
CB. But, the price of the CB WOULD FALL because 5% is NOT the rate that would exist on a
straight [non-convertible] bond; \$1,000 is NOT the instrinsic value of the bond. The rate on the
CB is 5% only because it carries the conversion privilege. The rate on a straight bond would be
higher than 5%.
Indeed Comment 11 acknowledges that the rate on a CB is lower than the rate on a straight bond.
The price of a CB consists of the price of a straight bond plus the price of the conversion
privilege [similar to a Call Option]. As the price of the stock falls from \$20 to \$15, the value of
the conversion privilege [Call Option] falls and so does the value of the CB. In Case 3, the
decrease in the value of the conversion privilege would exactly offset the other gains so that the
net inordinate gain (above the 5% interest) would equal zero. [The math here is pretty complex
and there is an assumption that the stock hedge was appropriate (dependent on the "delta" of the
stock) and that everything occurred instantaneously.]
It is true that CB investors usually hedge by shorting the stock. However, I have never seen an
adequate explanation of why they do it – unless, of course, they believe that the conversion
privilege is mispriced.
Remember Friedman’s dictum – There is no such thing as a free lunch.
If the proposed scheme worked, we would all be rich.
15. Jonathan Stanford
Joe L. you are absolutely correct. Many oversimplifications have been made in these examples,
and make it sound a lot easyer that it actually is. First of all they are assuming the CBs trade on
parity (same price as the value of the underlying stocks) which is not correct, as they trade on a
premium to parity (conversion premium). They also assume zero delta on the down and 100 delta
on the up. CBs actually start off at issue at-the-money (close to 50% delta). As you mention the
bond floor is below the market price, so if the stock falls, your CB will fall to its bond floor with
a delta shift decreasing as you go down. Another important omission in their examples is the cost
of dividends of the short stock. If you have a short stock position, you have to pay up the
dividend that the stock has payed. If there is no dividend protection in the prospectus, this can be
expensive…
I will try to give you the explanation you are looking for as to why they do it:
When you buy a CB you pay an implied level of future volatility in the stock. You hedge the
delta (say 50% to start off with). At this point you are market neutral as far as the stock
movement is concerned. If the stock falls the delta sensitivity of the CB will be lower, but you
still have your original 50% hedge on, so you will be making more money on the hedge than the
money you are loosing on the CB. At this point the delta may be 45% so in order to rebalance
your positon you buy back 5% hedge. If the stock goes back up, you are short 45% hedge but the
CB will be back to a 50% delta, so you will make more money on the CB than you lose on the
hedge.
In essence you are long volatility, because you have to continue to do this buy low sell high
trades (delta hedging) in order to make the same money you will lose on time value (conversion
premium). So in order to have many of these stock movements to rebalance, and therefore to
make profits, your stock has to trade at a realised volatility higher than the implied volatility you
payed on day one. If future realised volatility is lower, you WILL lose money.
Not to mention interest rate exposure, and above all, credit risk exposure…
Does that help?
Nov 16th, 2007 @ 1:14 pm
16. Joe Lavely
J Stanford -
Thanks.
Yes, your comments help. If I understand you correctly, the hedge [shorting the stock] is
inordinately profitable only if the conversion privilege [Call option] is mispriced – in your
explanation, actual volatility exceeds the level that is priced into the CB.
Anytime any security is mispriced, there is an opportunity for inordinate returns. But, I presume
that the Call options on almost all CBs are not mispriced; I presume that they are properly priced.
Accordingly, I still have the question as to why most CB investors do, in fact, short the stock.
Nov 16th, 2007 @ 1:30 pm
17. Jonathan Stanford
Joe – Actually there are opportunities, although they are rare. Usually CBs have rather long
maturities and often the longest quoted option market you will find is out 2 or so years. So its
difficult to put a “market” price the that kind of volatility. Also credit spread assumptions may
differ among market makers, so the CB market isn’t as efficient as you may think. Sometimes
you can buy “cheap” implied volatility, and then hope for increased realised volatility in the
future.
Another important use of CB arbitrage are carry trades. If you setup the trade as discussed above,
and strip the credit (by means of asset swaps) you actually use very little of your original cash.
Therefore you can put on a large degree of leverage, and your original coupon becomes massive
if compared to your original cash investment. Obviously, the borrow costs, and dividend costs
will also be leveraged.
Its tricky. As you said above, there if no free lunch, but if you are willing to put on the risk, then
the rewards could follow.
Nov 16th, 2007 @ 1:47 pm