Liquidity Provision in the Convertible Bond Market: Analysis of Convertible Arbitrage Hedge Funds

This paper analyzes the risk and rewards of providing liquidity to the convertible bond market.Using daily data on US and Japanese convertible bonds (CBs), we compute returns to a buy-andhedgearbitrage strategy involving a long position in CBs while hedging the equity, credit, andinterest rate risks. We find that this simple strategy can explain a large proportion of returnsearned by convertible arbitrage (CA) hedge funds. We also show the importance ofincorporating discrete exogenous shocks such as market disruption events and abnormal changesto the convertible arbitrageur’s opportunity set such as imbalances between supply and demandfor CBs. Finally, we demonstrate that the alphas of CA hedge funds can be explained by theoriginal issue discount in the primary CB market. Overall, the empirical findings are consistentwith the notion that arbitrageurs act as liquidity providers to the CB market. [Vikas Agarwal, William H. Fung, Yee Cheng Loon, Narayan Y. Naik