Convertible Bond Arbitrage Research Articles

Fixed-Income Portfolio Allocation Including Hedge Fund Strategies: A Copula Opinion Pooling Approach

This paper adapts Meucci9s [2006a, 2006b] copula opinion pooling (COP) framework to examine whether fixed income hedge fund strategies enhance the risk-return spectrum of traditional bond portfolios. In contrast to the Black-Litterman setup, the COP approach does not rely on linear dependencies, and avoids the problems associated with the assumption of normally distributed asset returns. We analyze three scenarios that represent investor expectations about the performance of fixed income portfolios, and we add fixed income hedge fund strategies such as fixed income arbitrage, convertible bond arbitrage, and distressed securities, given expected shortfall constraints. Our results suggest that investor market expectations and attitudes toward potential losses are both important in determining the relative weight of hedge funds in the optimal portfolio. Depending on the model parameters, the allocation to hedge funds can vary greatly, from 0% to 85%.

Convertible bond arbitrage, liquidity externalities, and stock prices

In the context of convertible bond issuance, we examine the impact of arbitrage activity on underlying equity markets. In particular, we use changes in equity short interest following convertible bond issuance to identify convertible bond arbitrage activity and analyze its impact on stock market liquidity and prices for the period 1993 to 2006. There is considerable evidence of arbitrage-induced short selling resulting from issuance. Moreover, we find strong evidence that this activity is systematically related to liquidity improvements in the stock. These results are robust to controlling for the potential endogeneity of arbitrage activity.

Simulating convertible bond arbitrage portfolios

The recent growth in interest in convertible bond arbitrage (CBA) has predominantly come from the hedge fund industry. Past empirical evidence has shown that a CBA strategy generates positive monthly abnormal risk-adjusted returns. However, these studies have focused on hedge fund returns which exhibit instant history bias, selection bias, survivorship bias and smoothing. This article replicates the core underlying CBA strategy to generate an equally weighted and market capitalization daily CBA return series free of these biases, for the period 1990 through 2002. These daily series also capture important short-run price dynamics that previous studies have ignored.

Earnings Management and Convertible Bond Arbitrage

We bring together two streams of research: one on earnings management and the other on convertible bond arbitrage. In doing so, we bring new insights on why convertible bond hedge funds benefit from convertible bond arbitrage. Specifically, we find that firms managing their earnings prior to their convertible bond issuance have: (1) poorer stock market and earnings performance after their issuance of convertible debt, (2) higher idiosyncratic volatility prior to issuance, (3) more equity like convertible bonds, and (4) an abnormal increase in the short selling of their stocks after issuance of convertible bond. Consequently, we provide evidence consistent with the notion that earnings management prior to the issuance of convertible bonds is a source of profits for convertible bond hedge funds that pursue convertible bond arbitrage.

Time-Varying Risk Exposure of Hedge Funds: Regime-Switching Approach

This article aims to investigate risk exposure of hedge funds using switching regime beta models. This approach allows to analyze hedge fund tail event behavior and in particular the changes in hedge fund exposure conditional on different states of various risk factors. Up to this point, most of the studies on hedge fund performance have been based either on (i) the classical linear factor model applied to mutual funds, (ii) non-parametric models or (iii) linear factor models with option-like factors. In this paper, in line with the asset pricing perspective proposed by Bekaert and Harvey (1995, 2002), we suggest to analyze the exposure of hedge fund indexes with a parametric factor model based on regime switching, where non-linearity in the exposure is captured by factor loadings that are state dependent. The regime switching approach is able to identify when the market risk factor is characterized by normal, up-market and crisis conditions, and the state dependent factor loading is able to capture the exposure of hedge fund indexes to the market risk factor in these different states. We find that in the normal state of the market, the exposure to risk factors could be very low but as soon as the market risk factor captured by S&P500 moves to a crisis state characterized by negative returns and high volatility, the exposure of hedge fund indexes to the S&P500 and other risk factors may change significantly. We further extend the regime switching model to allow for non-linearity in residuals and show that switching regime models are able to capture and forecast the evolution of the idiosyncratic risk factor in terms of changes from a low volatility regime to a distressed state that are not directly related to market risk factors. In particular, our analysis shows that the convertible bond arbitrage distress observed in 2005 is not related to a particular regime of the market index or some other systemic risk factor, but to a switch in the volatility of the idiosyncratic risk factor in this strategy.

Hedge Fund of Fund Allocations Using a Convergent and Divergent Strategy Approach

Hedge fund asset allocation can be a challenging endeavor given the dearth of tools available to deal with the unique statistical characteristics of long and short strategies. From a top-down perspective, the hedge fund industry is classified into several substyle categories including long/short equity, market neutral equity, convertible bond arbitrage, merger arbitrage, event driven, global macro, and managed futures. However, due to the non-correlated nature of rates of return in each style group, the problem of asset allocation appears overly simplistic. This article takes a different view of the hedge fund universe, classifying strategies as “convergent” or “divergent” in their orientation and thereby adding new meaning to the process of asset allocation. Convergent strategies tend to view the asset world as being mostly efficient, seeking to profit from small asset mispricings. Divergent strategies are based on the premise that from time to time, the market is inefficient, providing opportunities that can be exploited by using price series analysis and autocorrelations when pricing certain portfolio assets. Since convergent strategies tend to be “short volatility” and divergent strategies “long volatility,” using a top-down asset allocation policy that recognizes this asset dynamic can lead to a more efficiently allocated hedge fund portfolio. The results of this study show the time-varying validity of the divergent strategy and its potential benefits as a portfolio component. Since the divergent strategy experiences significantly higher performance during the periods of increasing market uncertainty, when it is combined with the convergent strategy, the portfolio experiences increased return and reduced risk with more favorable return distributions relative to the individual convergent strategies.