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

Agarwal, V, Naik, N and et, al. (2006) Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market. Working Paper. London Business School BNP Paribas Hedge Fund Centre Working Paper Series.

Abstract

This paper analyzes the riskreturn characteristics of convertible arbitrage (CA) strategy. Using data on US and Japanese convertible bonds (CBs), we create three basic strategies commonly employed by arbitrageurs in the CB market. We compute returns on these strategies and show that they explain a significant proportion of the variation in returns of CA hedge funds. We provide empirical results showing how CA hedge funds respond to extreme market events such as LTCM crisis. Finally, we demonstrate that the riskadjusted returns of CA hedge funds are affected by mismatches between supply of and demand for CBs. After adjusting for these mismatches, empirical evidence reveals no abnormal returns accruing to CA hedge funds. Our findings are consistent with arbitrageurs acting as liquidity providers to the CB markets.