Convertible Arbitrage

Insights and Techniques for Successful Hedging

Nick P. Calamos

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118045664
• Edition: 1
• Topic: Commerce
• Subtopic: Investissements et valeurs mobilières

Minimize risk and maximize profits with convertible arbitrage
Convertible arbitrage involves purchasing a portfolio of convertible securities-generally convertible bonds-and hedging a portion of the equity risk by selling short the underlying common stock. This increasingly popular strategy, which is especially useful during times of market volatility, allows individuals to increase their returns while decreasing their risks. Convertible Arbitrage offers a thorough explanation of this unique investment strategy. Filled with in-depth insights from an expert in the field, this comprehensive guide explores a wide range of convertible topics. Readers will be introduced to a variety of models for convertible analysis, "the Greeks, " as well as the full range of hedges, including titled and leveraged hedges, as well as swaps, nontraditional hedges, and option hedging. They will also gain a firm understanding of alternative convertible structures, the use of foreign convertibles in hedging, risk management at the portfolio level, and trading and hedging risks. Convertible Arbitrage eliminates any confusion by clearly differentiating convertible arbitrage strategy from other hedging techniques such as long-short equity, merger and acquisition arbitrage, and fixed-income arbitrage.
Nick Calamos (Naperville, IL) oversees research and portfolio management for Calamos Asset Management, Inc. Since 1983 his experience has centered on convertible securities investment. He received his undergraduate degree in economics from Southern Illinois University and an MS in finance from Northern Illinois University.

CHAPTER 1

Conveertible Arbitrage: An Overview

There was a time when the word “arbitrage” brought to mind a picture of a mysterious realm in finance which few people seemed to be inclined or at least to have the knowledge to discuss. I knew in a general way that profits depended upon price differences, but I believed that it was with lightning speed at a nerve-racking pace that computations, purchases, and sales must be executed in order to reap a profit.

—Meyer H. Weinstein, Arbitrage in Securities

CONVERTIBLE ARBITRAGE: A BRIEF HISTORY

The practice of convertible arbitrage includes the traditional purchase of a convertible while shorting its underlying stock, but also includes warrant hedging, reverse hedging, capital structure arbitrage, and various other techniques that exploit the unique nature of the global convertible and warrant marketplace. While the quantitative modeling, arcane mathematics, and hedge fund strategies affiliated with such techniques may make the practice seem a symbol of the latest in financial innovation, it has actually been around for more than a century, practically since the launch of convertible securities. Convertible securities came into being as a way to make securities more attractive to investors. Convertible bonds are not new; issuers and investors have been using them since the 1800s. During the nineteenth century, the United States was what we would now classify as an emerging market. It was not easy to gain access to capital in a rapidly growing country. The convertible clause was added first to mortgage bonds to entice investors to finance the building of the railroads. The Chicago, Milwaukee & St. Paul Railway, for example, used many convertible issues for financing between 1860 and 1880. In 1896, that company had 12 separate convertible issues outstanding, most bearing a 7 percent coupon.

Convertible securities are relatively simple in concept: A convertible bond is a regular corporate bond that has the added feature of being converted into a fixed number of shares of common stock. Conversion terms and conditions are defined by the issuing corporation at issuance. (A convertible security may also be preferred stock, but convertibles are best understood by studying convertible bonds.) The actual terms can vary significantly, but the traditional convertible bond pays a fixed interest rate and has a fixed maturity date. The issuing company guarantees to pay the specified coupon interest, usually semiannually, and the par value, usually $1,000 per bond, upon maturity. Like other nonconvertible bonds, a corporation’s failure to pay interest or principal when due results in the first step toward company bankruptcy. Therefore, convertible bonds share with nonconvertible bonds the feature that bond investors consider most precious: principal protection. Convertibles are senior to common stock but may be junior to other long-term debt instruments. Convertibles have one important feature that other corporate bonds do not have: At the holder’s option, the bond can be exchanged for the underlying common stock of the company. This feature completely changes the investment characteristics of the bond, and is one of the characteristics that make convertible arbitrage possible.

Meyer Weinstein’s 1931 book, cited above, notes that with the advent of rights, warrant options, and convertible securities that began during the 1860s railroad consolidation, arbitrage in equivalent securities was born. By the 1920s, the practices and techniques established became the focus of Weinstein’s book; while rudimentary, they were effective. Most of the convertible, warrant, and rights arbitrage positions depicted in the book either offered discounts to parity at conversion, or were passive hedges without mathematical precision. Although lacking the exactitude required today, these hedges were driven by the same premise: to successfully exploit the non-linear relationship of the convertible with respect to the underlying stock:

If the price of the stock and the convertible security of a company are not rising and falling together, there is an opportunity for the arbitrageur to take a long position in the convertible security, and a short position in the stock into which the convertible security is convertible. When the convertible security is selling at a price close to its investment value, and the price of the stock into which it is convertible is not at a great discount, the arbitrageur may buy the convertible security and sell one-half of the stock short, leaving himself in a position of being theoretically long and short at the same time. In this form of arbitrage he is hedged against either a rise or a fall of the stock, and any rise in the convertible security will be a profit. (Weinstein, Arbitrage in Securities, p. 151)

Weinstein is describing a classic convertible “market-neutral” hedge, still a cornerstone of contemporary convertible arbitrage practices. Without the benefit of option pricing models or financial calculators, however, the early years of arbitrage resembled more art than science. The author does not attempt to quantify investment values (fixed income components), and most hedging is based on shorting simply “one-quarter,” “one-half,” or “three-quarters” of the stock against the long convertible position. Since the same limits of precision applied to the whole marketplace, presumably greater inefficiencies still left room for successful arbitrage. Despite the simpler nature of the hedging described in this book written more than 70 years ago, it remains remarkably relevant to convertible arbitrage practiced today. The book ventured into some of the pitfalls and basic necessities, including margin, short interest rebates, trading, merger arbitrage, and even international securities arbitrage.

In 1967, Edward O. Thorp’s and Sheen T. Kassouf’s book, Beat the Market, became a must read for the convertible and warrant arbitrage community. This may be the first book that approached the convertible arbitrage market in a mathematical format. (Thorp had already made a name for himself as a master of quantitative systems a few years earlier, when his bestselling book, Beat the Dealer, introduced card counting to players of Black Jack.) The authors advanced the concept of breaking down convertibles into two components, bond and warrant, and quantifying each separately in order to identify hedging opportunities. Using their approach, they sought to identify a convertible when priced close to its value strictly as a fixed-income instrument (its investment value), while also selling close to its equity value (conversion value). Issues with these attributes tend to be undervalued and offer good downside protection (being priced close to their bond “floor”), along with a high degree of upside participation should the stock price rally. Not content with the returns of a market-neutral strategy, Thorp and Kassouf also looked for the opposite hedge opportunity by identifying overpriced issues and applying a ratio hedge (a strategy to be discussed in Chapter 9). The authors’ portrayals of their successes in ratio and reverse hedging thus promoted using mathematical formats well beyond Weinstein’s less precise market neutral hedges, and signaled the beginnings of the complex quantitative modeling techniques that make up the toolbox of the modern convertible arbitrageur.

John Calamos’ book, Convertible Securities, 1985, was the first complete book on convertibles and included option price theory applied to convertible valuation as well as many convertible hedging techniques.

Moving from the conceptual breakthrough of separately valuing a convertible’s bond and option components to the current state of convertible arbitrage, the range of opportunities is clearly wider than at any time in the past, due largely to the rapid growth in the global convertible market, augmented by improvements in technology, financial models, innovative derivative products, and global information flows. With this unprecedented breadth in the opportunity set comes unprecedented complexity, competition, and even new kinds of risks. During this same period, hedge funds have both benefited from and contributed to the growth of convertible arbitrage: As the benefits of the asset class have become more apparent to issuers and to investors, issuance and liquidity have grown exponentially, with hedge funds providing a large role in demand. Typically, most investors who gain access to the convertible arbitrage arena do so through hedge funds.

Although A.W. Jones founded the first hedge fund in 1949, the concept remained virtually unknown until 1966, when Fortune magazine highlighted Jones’s investment feats. The hedge fund “industry” sprouted up in the next few years as a number of investors (including Warren Buffett) delved into hedging techniques. (The timing of this first wave of hedge funds corresponds with the publication of Beat the Market, and is another example of the emergence of quantitative analysis, which began its dramatic, ongoing influence on the investment community.) During the 1970s, the macro investment hedge funds popularized by George Soros made large bets regarding currency, bond, equity, and commodity markets across the globe. These funds were not necessarily hedged nor were they considered market neutral. The bull market of the 1980s and 1990s helped fuel the hedge fund industry’s growth as investors looked for even better returns or non-correlated return profiles.

The 1990s produced the hedge fund industry’s greatest growth, as it moved from the margins to the mainstream, at least among high-net-worth circles. The globalization of the marketplace, combined with the tremendous wealth creation and technological progress during that decade, all fed the growth of the hedge fund industry. The hedge fund industry today includes funds that specialize in one hedge strategy as well as funds of funds that include a full spectrum of hedge fund strategies. According to Hedge Fund Research Inc., the hedge fund universe was estimated to include less than 200 funds with approximately $20 billion in assets in 1990; by 2000, over 4,500 funds existed with nearly $500 billion in assets—not including leverage. The assets employed in convertible arbitrage strategies have also grown dramatically. According to Tremont Advisors, assets in convertible arbitrage have increased 25-fold over the past nine years. See Figure 1.1.

The hedge fund universe can be roughly divided into two camps: directional strategies that participate in market movements, and non-directional strategies, whose returns are for the most part unaffected by broad market moves. Convertible arbitrage is placed in this second group, along with other arbitrage practices that tend to gain more investor attention during sideways or declining markets. For example, during the corporate-scandalridden second quarter of 2002, more than half of all new hedge fund inflows went to either equity or convertible arbitrage strategies, according to Tremont Advisors Research. The following list ...