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Definition: Convertible Bond Arbitrage
Convertible bond arbitrage is a method to earn money using the price difference between a convertible bond and its stock. In US, Europe and Japan, corporate convertible bonds are main target for the arbitrageurs. Convertible bonds are hybrid bonds with features of both stocks and bonds. They are flexible enough to be converted to stocks at any pre-determined time and price.
Here the arbitrageur exploits the price difference by making various long and short positions in both the bonds as well as stocks depending whether they are overvalued or undervalued in the market and make money out of that mispricing.
The most important players in this Convertible Bond market are hedge funds. They buy convertible bonds which are under priced at issuance and then use arbitrage strategy to earn profits out of it
This method is not risk averse as one must hold the convertible bonds for a specified time before converting it into stock , it is important for the arbitrageur to carefully judge the market and make sure if market conditions will match with the time frame in which conversion is permitted.
The arbitrageur should also be aware of risk of unpredictable events when the convertible bonds value may decline more than that of stocks in which they were convertible which can lead to a huge loss for the arbitrageurs.
Another risk is when many arbitrageurs take long positions in convertible bonds and short positions in stock, and if at the same time the promoter of the company or a big investor tries to buy back a huge stack from the market, this can make arbitrageurs go into huge losses.
So the arbitrageurs must carefully evaluate the market and the potential returns before getting into this type of arbitraging.