KBC Alternative Investment Management (A): Convertible Bond Arbitrage

Published 10 Jan 2004
Reference 5225
Industry Venture Capital
Region Europe
Summary

Case A: To extract “cheap” volatility in Duke Energy convertible bonds, Mark Punt, a convertible arbitrageur at KBC AIM, purchases the bonds and delta hedges them with a short position in the company’s shares. To manage the credit risk of his long convertible bond position, Mark faces a choice of hedging with CDS, shares of the company or out-of-the-money puts on the company’s stock. Key to his hedging strategy is an understanding of the observed negative correlation between credit spreads and share prices for Duke Energy. Case B: Based on a Merton-type structural model of credit risk, Steve Dash, a trader at KBC AIM, perceives that British Airways’ CDS are mispriced relative to the company’s share price. Steve has to figure out which trades to put on to exploit the potential mispricing and what the main profit drivers of this strategy are. At the same time, he needs to be aware of the risks of his strategy and whether the “mispricing” could be attributable to factors that his capital structure arbitrage model isn’t able to capture.

Teaching objectives

Case A: To illustrate convertible bond arbitrage (exploiting mispriced volatility and gamma trading) and how to hedge the credit risk of the position using credit default swaps or equity products based on an understanding of the relationship between credit spreads and share prices. Case B: To illustrate capital structure arbitrage as a strategy to exploit mispricing between debt (bonds or CDS) and equity based on a Merton model of a credit risk. Link to convertible bond arbitrage.

Keywords
  • Convertible bond
  • Arbitrage
  • Hedge fund
  • Volatility
  • Credit derivatives
  • Debt-equity trading
  • Merton models
  • Credit risk. AR2004
  • AR0405
  • RD0904