As mentioned in this blog, hedge funds all operate on specific strategies. For the next few posts I will be covering a few of the specific strategy types hedge funds will commonly employ. This post will cover: Convertible Arbitrage
The Convertible Arbitrage strategy uses the long/short strategy that takes a long strategy in a specific convertible security and a short strategy in the same company’s common stock. The convertible securities are typically convertible bonds and convertible preferred stock.
A convertible security can be converted into another security at a specific, predetermined time at a predetermined price (usually a bond that can converted into a stock). So, a convertible bond holder can hold the bond as-is, or convert it to a stock if there is an anticipation of a rasied stock price.
The money is made through capitalization on the mis-pricing & inefficiencies in pricing between that convertible security and the common stock. There are times when the convertible bonds’ pricing is priced inefficiently in relation to the company’s common stock. If and when that happens, the convertible arbitrage strategy is set in motion to take advantage of that error in pricing.
For example: A hedge fund purchases both convertible bonds and common stock in one company. If the company’s stock price increases, the fund can convert its convertible bonds into stock, sell at market value, and make a profit on the sale.
This may sound like an easy way to profit, but Convertible Arbitrage is not without risk. The timing of the transactions must be correct; the convertible bonds will often have a specified holding time before they can be converted to stock.A great deal of analysis must go into whether or not this particular strategy will be successful; the fund will operate at a loss (or lack of success) if the proper conditions arise, and the bonds cannot be converted.
Melissa Ko is the Managing Member of Covepoint Capital Advisors, LLC and serves as the Chief Investment Officer of its flagship, the Covepoint Emerging Markets Macro Fund. Please visit https://about.me/melissako, https://melissakoblog.wordpress.com/, http://melissakocovepoint.tumblr.com/, and http://www.slideshare.net/MelissaKo1 to learn more!