TAILIEUCHUNG - Hedges on Hedge Funds Chapter 8

CHAPTER 8 Evaluating Arbitrage and Relative Value Strategies. This chapter discusses two prominent types of nondirectional strategies, which help investors to isolate and capture as profit the difference in value between two related securities, regardless of the direction of the overall markets. | 8 Evaluating Arbitrage and Relative Value Strategies This chapter discusses two prominent types of nondirectional strategies which help investors to isolate and capture as profit the difference in value between two related securities regardless of the direction of the overall markets. Thus the term nondirectional refers to the idea that each strategy in this category attempts to build on the notion that skilled managers can profit in any market conditions. The terms arbitrage and relative value refer to the specific ways in which the three strategies considered in this chapter attempt to achieve alpha for investors. Strictly defined arbitrage refers to a completely riskless trade that involves buying a security at a lower price in one market and immediately selling at a higher price in another market. In reality such purely riskless trades do not exist and so in actual practice the term refers to attempts to approximate such conditions through complicated arrangements of trades in different but closely related securities. The two arbitrage strategies considered in this chapter are convertible arbitrage and fixed-income arbitrage. CONVERTIBLE ARBITRAGE HEDGE FUND INVESTING To understand how the convertible arbitrage strategy invests and trades in convertible securities it is helpful to review some basics related to convertible securities. A convertible bond is a straight corporate bond 111 112 HEDGES ON HEDGE FUNDS Underlying Stock Price Convertible Price Stock Price FIGURE Convertible Bond Price Behavior. with an option that allows the bondholder to convert to equity at predetermined periods and at a predetermined exchange rate which is an agreed on number of common shares known as the conversion rate. A convertible bond thus has certain characteristics of both a bond and a stock. As a fixed-income instrument a convertible bond provides investors with downside protection in the form of guaranteed interest payments and principal protection. At the same time a .

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