Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market

57 Pages Posted: 15 Aug 2008 Last revised: 15 Jan 2011

See all articles by Vikas Agarwal

Vikas Agarwal

Georgia State University; University of Cologne - Centre for Financial Research (CFR)

William Fung

PI Asset Management, LLC

Yee Cheng Loon

Securities and Exchange Commission (SEC)

Narayan Y. Naik

London Business School - Institute of Finance and Accounting

Date Written: December 8, 2010

Abstract

In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantial amount of these funds’ return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model’s predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.

Keywords: Hedge Funds, Convertible Bonds, Convertible Arbitrage, Supply, Risk Factors

JEL Classification: G1''8 G19, G23

Suggested Citation

Agarwal, Vikas and Fung, William (Bill) and Loon, Yee Cheng and Naik, Narayan Y., Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market (December 8, 2010). Journal of Empirical Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=885945

Vikas Agarwal (Contact Author)

Georgia State University ( email )

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HOME PAGE: http://vagarwal.gsucreate.org/

University of Cologne - Centre for Financial Research (CFR) ( email )

Albertus-Magnus Platz
Cologne, 50923
Germany

William (Bill) Fung

PI Asset Management, LLC ( email )

79 Wellington Street West
Suite 3500
Toronto, Ontario M5K 1K7
Canada

Yee Cheng Loon

Securities and Exchange Commission (SEC) ( email )

100 F Street NE
Washington, DC 20549
United States

Narayan Y. Naik

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 20 70008223 (Phone)

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