Hedge Funds - Convertible Arbitrage

Convertible Arbitrage - This hedge fund strategy primarily involves taking long positions in convertible bonds hedged with a short position, typically in the underlying stock. Convertible bonds and warrants are priced as a function of the price of the underlying stock, expected future volatility of returns, risk-free rates and the issuer-specific corporate yield spread. However, in many cases, convertible bonds and warrants are not accurately priced due to illiquidity in the convertible and warrant markets compared to the markets in the underlying common equity of the stocks, uncertainty concerning the call and redemption features of convertible securities and lesser focus on these derivatives as opposed to the equities into which they are convertible or exercisable. These mispricings may lead to significant profit opportunities for hedge funds, as positions are acquired in anticipation of the market price eventually reflecting true value. Historically, this strategy has been one of the best hedge fund approaches in terms of Sharpe Ratio.