Convertible arbitrage strategies o these investors

convertible arbitrage strategies
o These investors typically purchase the convertible and simultaneously sell short a
certain number of the issuers common shares that underlie the convertible
o The number of shares they sell short as a percent of the shares underlying the
convertible is approximately equal to the risk neutral probability at that point in
time that the investor will eventually convert the security into common shares
o This probability is then applied to the number of common shares the convertible
security could convert into to determine the number of shares the hedge fund
investor should sell short (the hedge ratio)
o Volatility risk Example

 Company’s share price is $10 at the time of its convertible issuance. A
hedge fund purchases a portion of the convertible, which gives the right
to convert into 100 common shares of the issuer
 If the hedge ratio is 65%, the hedge fund may sell short 65 shares of the
issuers stock on the same date as the convertible purchase
 During the life span of the convertible, the hedge fund investor may sell
more shares short or buy shares, based on the changing hedge ratio
 To illustrate, if one month after purchasing the convertible, the issuers
share price decreases to $9, the hedge ratio may drop from 65% to 60%
 To align the hedge ratio with the shares sold short as a percent of shares,
the investor has the right to convert the security into, the hedge fund
investor will need to buy five shares in the open market from other
shareholders and deliver those shares to the parties who had lent the
share originally
 Covering five shares of their short position leaves the hedge fund with a
new short position of 60 shares
 If the issuers share price two months after issuance increases to $11 the
hedge ratio may increase to 70%
 The investor achieves this position by borrowing 10 more shares and
selling them short, which increases the short position from 60shares to
70 shares
 This process of buying low and selling high continues until the convertible
either converts or matures
 Nikkei Put Warrants
o One question high level on the Nikkei Put Warrants
 Accelerated Share Repurchase Program (ASR)
o Companies need to raise financing and so issue securities
o Companies need to reduce cash on balance sheet so repurchase shares back
(which goes into the treasury stock) – benefits EPS, employee options
o 10(b)5 limits share repurchases to less than or equal to 25% of ADTV (average
daily trading volume)
 Eg. IBM
Final Exam
 Easy calculations (3-4)
 Case questions
 Chapter questions
 Too big to fail
 Class stuff
