Convertible Arbitrage
Insights and Techniques for Successful Hedging
Convertible
arbitrage is a trading strategy employed by many hedge funds. At its heart, the strategy takes advantage of the fact that convertible
bonds can be devilishly hard to value. In theory, a trader with the right tools
can identify mis-pricings, put on some sort of long-short hedge, and realize a
profit.
Calamos has
written a wonderful non-technical introduction to the discipline. He opens with
a brief overview of convertible arbitrage and its history. He delves into the
complex nature of convertibles, which blend aspects of fixed income, equity and
options markets. There is brief information on financial engineering issues of
valuation and an in-depth discussion of credit valuation issues. Calamos
describes the fundamentally different dynamics of convertibles that are
in-the-money, out-of-the-money, distressed, or "busted." He introduces the
standard Greek sensitivities—delta, gamma, vega, theta and rho—as well as some
new ones that are more specific to convertibles—omicron, upsilon and phi. He
also describes convertibles with various "whistles and bells"—including
mandatory convertibles and reset convertibles (also called "death spiral"
convertibles).
8. Convertible Asset Swaps and Credit
Default Swaps
9. Non-traditional Hedges
10. Portfolio Risk Management
The heart of the
book is its discussion of standard hedge/arbitrage techniques, including delta
hedges, gamma capture hedges and exchange-traded options hedges. There isn't
much rocket science here. The techniques entail buying convertibles with
undervalued optionality and then putting on a static delta, static gamma or
dynamic hedge. However, the discussions are insightful, identifying issues and
pitfalls that convertibles pose. A chapter discusses hedges that use credit
derivatives to strip optionality from the credit risk. Another lengthy
chapter discusses a variety of less common hedges. Most apply in unique
circumstances, such as corporate distress or mergers.
While the book's
non-technical nature is a strength, it is also a weakness. The key to any
convertible arbitrage strategy is having a sophisticated valuation methodology.
While Calamos covers the credit aspects of valuation in detail, his treatment of
the financial engineering aspects is not something you could base a model on. In
fairness, this aspect of convertible valuation is an extremely technical topic,
and any attempt to do it justice would fundamentally change the character and
audience of the book.
In summary, this
is a highly readable book. It is non-technical, but does not sacrifice depth.
The book will teach you much about convertible arbitrage—as well as convertible
bonds generally. It will appeal primarily to institutional investors who either
invest in or are contemplating investing in hedge funds that employ convertible
arbitrage. It is also a nice book for traders, risk managers, systems staff or
back office employees to get oriented to the discipline. However, if you want to
implement any of the techniques, you better be a financial engineer—or hire one!
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