A Liquidity-Based Explanation of Convertible Arbitrage Alphas

We examine the extent to which excess returns from convertible arbitrage represent positive returns to managers to exploiting pricing inefficiencies versus compensation for exposure to systematic risk factors. Initial empirical tests show that when we exclude liquidity risk as a factor, a good portion of abnormal returns to convertible bond strategies appears to be driven both by overpricing of the underlying equity and apparent underpricing of convertible bonds. However, when we include the effects of liquidity, abnormal returns to convertible bond arbitrage essentially disappear and only remain localized in convertible debt trading closer to the issuance date