When it comes to generating returns from the stock market, there’s no dearth of strategies that you can use. Apart from the popular technical and fundamental strategies, there’s also another segment that investors are barely aware of – arbitrage strategies.
These strategies are mostly utilized by huge institutional investors like hedge funds and are great low-risk options to generate returns. If you’re wondering what convertible bond arbitrage is, here’s what you should know.
But before we delve into the specifics of convertible arbitrage, let’s quickly run through the concept of arbitrage itself.
What is arbitrage?
Arbitrage is a trading and investment strategy that involves the exploitation of mispricings of an asset class in different markets to generate profits. The profit that you generate out of an arbitrage strategy is the difference between the prices of the asset in two different markets. Let’s take up a hypothetical scenario to better understand the concept of arbitrage.
Assume that the stock of Infosys is currently trading at around Rs. 800 in the NSE and at around Rs. 798 in the BSE. Since there’s a pricing difference for the same asset (which, in this case, is the Infosys stock) in two different exchanges, you can deploy an arbitrage strategy to earn profits.
So, to successfully execute an arbitrage strategy, you would have to purchase the Infosys stock at Rs. 798 in the BSE and immediately sell the same stock at around Rs. 800 in the NSE. The difference of Rs. 2 would then be your profit from this trade. This is a virtually risk-free trading strategy.
Now that you’re aware of what arbitrage is, let’s jump right into the concept of convertible arbitrage strategy.
What is convertible bond arbitrage?
To understand the specifics of the convertible arbitrage strategy, let’s get to know what convertible bonds are.
Convertible bonds are essentially fixed-income debt instruments issued by a company as part of a fund raising exercise. However, upon maturity of these instruments, the investor can convert these bonds into equity shares of the company at a predetermined conversion rate. Here, the underlying assets in a convertible bond of a company are the equity shares of the said company. Furthermore, convertible bonds are also usually traded in the market just like the shares of the company.
Now, convertible arbitrage is a trading strategy that aims to exploit the price difference between a convertible bond issued by a company and its underlying equity shares. In order to successfully execute a convertible bond arbitrage, you’re required to go long on a convertible security such as a bond and simultaneously go short on the bond’s underlying stock.
Once a convertible arbitrage strategy is executed, one of three scenarios is likely to happen. Let’s analyze each scenario one after the other to understand the workings of a convertible arbitrage.
Scenario 1: The price of the stock falls
In this situation, the short position on the stock of the company would start to make gains. Simultaneously, the price of the convertible bond would witness a fall. But, the impact of the fall in its price is likely to be quite limited since it is a fixed-income instrument. The difference between the gains from the short position and the fall in the price of the convertible bond would end up being the profit that you get to enjoy.
Scenario 2: The price of the stock rises
Here, the short position on the stock of the company would start to make losses. However, the gain in the price of the convertible bond would end up reducing the impact of the loss. Convertible arbitrage provides you with limited protection from losses that you experience due to upsides in the asset’s price.
Scenario 3: The price of the stock is range bound
In a scenario where the stock price is trading sideways, the convertible bond would still continue to generate gains by way of periodic interest payments. These gains can then be used to compensate for the costs associated with the short position on the company’s stock. Here, you would most likely end up with a no profit no loss situation.
As you can see, a convertible arbitrage strategy can be put to good use to earn profits from a trade. That said, this technique is effective and would generate returns in a market that’s trending downwards. Therefore, it is a good idea to thoroughly analyze the market movements to ensure that the market is in a downtrend before employing a convertible arbitrage strategy.