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

In this paper, we identify and document the empirical characteristics of the key drivers ofconvertible arbitrage as a strategy and how they impact the performance of convertible arbitragehedge funds. We show that the returns of a buy-and-hedge strategy involving taking a longposition in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantialamount of these funds’ return dynamics. In addition, we highlight the importance of non-pricevariables such as extreme market-wide events and the supply of CBs on performance. Out-ofsampletests provide corroborative evidence on our model’s predictions. At a more micro level,larger funds appear to be less dependent on directional exposure to CBs and more active inshorting stocks to hedge their exposure than smaller funds. They are also more vulnerable tosupply shocks in the CB market. These findings are consistent with economies of scale thatlarge funds enjoy in accessing the stock loan market. However, the friction involved in adjustingthe stock of risk capital managed by a large fund can negatively impact performance when thesupply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurscollectively being rewarded for playing an intermediation role of funding CB issuers whilstdistributing part of the equity risk of CBs to the equity market.