What is Convertible Arbitrage?

There are many strategies you can use to generate returns from the stock exchange. Investors aren't aware of an additional segment, arbitrage strategies.

These strategies are mainly used by large institutional investors such as hedge funds. They are low-risk and great options for generating returns. Here's what you need to know about convertible bond arbitrage.

Before we get into the details of convertible arbitrage let's briefly go over the concept of arbitrage.

What's arbitrage?

Arbitrage refers to a trading strategy and investment strategy that exploits mispricings in asset classes in different markets to make profits. An arbitrage strategy generates profit by comparing the prices of assets in different markets. Let's look at a hypothetical scenario in order to better understand arbitrage.

Let's say that Infosys stock is trading at Rs. 800 in the NSE, and around Rs. 798 in BSE. Arbitrage strategies can be used to make profits because there is a price difference for the same asset (in this case the Infosys stock).

To successfully execute an arbitrage strategy you would need to buy the Infosys stock for Rs. 798 in BSE, and then immediately sell the stock for Rs. 800 in the NSE The difference of Rs. This would be your profit. This strategy is virtually risk-free.

Let's now understand what arbitrage is.

What is convertible bond arbitrage?

Let's learn more about convertible bonds to understand the details of the conversion arbitrage strategy.

Convertible bonds can be described as fixed-income debt instruments that are issued by companies to raise funds. These bonds can be converted into equity shares by the investor at a predetermined rate once they mature. The equity shares of a company are the underlying assets of a convertible bond. Convertible bonds can also be traded on the market, just like shares.

Convertible arbitrage refers to a trading strategy which aims at exploiting the price difference between convertible bonds issued by companies and their underlying equity shares. To successfully execute a conversion bond arbitrage, it is necessary to be long on a convertible security like a bond while simultaneously being short on its underlying stock.

One of the three possible scenarios will occur once a convertible arbitrage strategy has been executed. Let's look at each scenario individually to better understand how a convertible arbitrage works.

Scenario 2: The stock price falls

The short position in the stock would begin to gain. The price of the convertible bonds would also fall simultaneously. The impact of the convertible bond's price falling is unlikely to have much effect since it is a fixed income instrument. You would get the difference between the gains from the shorter position and the fall of the price convertible bond.

Scenario 2, The stock price rises

This would mean that the short position in the stock of the company could start to lose money. The loss would be reduced by the increase in the price for the convertible bond. Convertible arbitrage offers limited protection against losses you may experience as a result of upsides in asset price.

3: The stock price is range bound

Even if the stock price fluctuates, the convertible bond will still generate interest payments that provide periodic gains. These profits can be used to offset the cost of the stock's short position. This would result in a situation where there is no profit and no loss.

Conclusion

You can use a convertible arbitrage strategy to make profits on trades, as you can see. This strategy is efficient and can generate returns in a market trending downwards. Before using a convertible arbitrage strategy, it is important to analyze the market movements thoroughly.