Convertible arbitrage.

In plain English

Convertible arbitrage pairs a long position in a convertible bond with a short position in the issuer's common stock, so the trade can pay off whether the share price rises or falls. A convertible bond can be swapped for a set number of shares, which means it behaves partly like a bond and partly like a stock option. The manager estimates what that embedded option is worth, then shorts enough shares to cancel out the bond's sensitivity to the stock price. What remains is exposure to the bond's yield, to changes in volatility, and to the gap between market price and calculated value. These positions are usually funded with borrowed money, so small pricing gaps get magnified in both directions.

01Why it matters

Most people meet this strategy inside a hedge fund or multi-strategy fund being pitched to them, and the returns depend on borrowing and short selling rather than on any company doing well.

02The math, step by step

Say a convertible bond trades at $980 and a manager's model values it at $1,000. Buying 100 bonds costs $98,000, and the gap is $20 per bond, or $2,000 total. If the gap closes, that is $2,000 on $98,000, about 2.0 percent, before borrowing costs and before the short position moves against the trade.

Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.

03What this is NOT

04Receipts

Every figure on this page is sourced to a primary document. Tap to open the original.