Table of Contents
Chapter 1 Convertible Arbitrage: An Overview 1 Convertible Arbitrage: A Brief History 1
Why Hedge with Convertibles? 6
Convertible Arbitrage Performance 7
What About Risks? 12
Basics of Convertible Securities 15
Risk-Reward Analysis 18
Methods of Valuation 18
Convertible Profile Graph 22
Basics of Convertible Arbitrage 23
Multiple Convertible Structures 26
Appendix 1.1 32
Chapter 2 Valuation 34
Convertible Valuation Models 34
Binomial Option Model 34
Chapter 3 The Greeks 48
Measures of Risk 48
Delta (∆) 48
Gamma (Γ) 51
Vega (v) 55
Theta (ϑ) 57
Rho (ρ) 59
More on Volatility 61
Chi (χ) 64
Omicron (ο) 65
Upsilon (u) 67
Phi (f) 69
Mandatory Convertible Greeks 70
Chapter 4 Credit and Equity Considerations 74
Credit Evaluation 74
Credit Analysis and Equity Market Feedback 76
Asset Value Credit Evaluation 79
Cash Flow and Valuing a Business 85
Business Valuation Model 85
I. Cash Inflows: Capital Employed 87
II. Cash Outflows: Economic Profit 94
III. Cash-Inflow Model 100
IV. Intrinsic Business Value 106
Chapter 5 Convertible Arbitrage Techniques—Delta Hedging 110
Delta Neutral Hedge (Long Volatility) 112
Delta Estimates versus Theoretical Deltas 117
Dynamic Rebalancing of the Delta Neutral Hedge 117
Delta Neutral Hedge on Leverage 120
Delta Hedge—Currency Hedge Overlay 122
Appendix 5.1 128
Appendix 5.2 131
Chapter 6 Gamma Capture Hedging 134
Capturing the Gamma in a Convertible Hedge 134
Bearish Tilt Gamma Convertible Hedge 141
Bearish Gamma Hedge on Leverage 143
The Gamma Tilt Hedge’s Role in a Market Neutral Portfolio 145
Chapter 7 Convertible Option Hedge Techniques 148
Covered or Partially Covered Convertible Call Option Hedge 151
Long Convertible Stock Hedge with Call Write Overlay 154
Synthetic Bond—Long Busted Convertible with Call Write and Long Out-of-the-Money Call for Protection 157
Convertible Stock Hedge—Put Purchase Provides Additional Downside Protection 161
Convertible Hedge Call Write with Protective Long Put 165
Mandatory Convertible Preferred—Stock Hedge with Call Write Overlay 169
Chapter 8 Convertible Asset Swaps and Credit Default Swaps 172
Convertible Asset Swaps—Extracting Cheap Options from Investment-Grade Convertibles 172
The Mechanics of Convertible Asset Swapping 173
Swap Hedge Setup 176
Convertible Bond Credit Default Swap—Transfer Credit Risk in a Hedge 179
Appendix 8.1 185
Chapter 9 Non-traditional Hedges 194
The Reverse Hedge 194
Call Option Hedge: Monetization of a Cheap Embedded Call Option 199
Stock Hedge to Capture Cheap or Free Put Options 200
Convergence Hedges 210
Merger and Acquisition Risk Arbitrage Trades 217
Reset Convertibles (or Death Spiral Convertibles) 218
Capital Structure Hedge 218
Distressed Convertible Hedge or Negative Gamma Hedge Opportunities 220
Basket Hedging Equity Delta 231
Synthetic Worksheet Hedge 234
Dividend Reduction Convertible Hedge 236
Trading Desk Value Added 239
Trade Execution 240
Appendix 9.1 242
Appendix 9.2 244
Take-Over Risks—An Example 244
Chapter 10 Portfolio Risk Management 248
Balance Sheet Leverage 250
Scenario Analysis 252
Hedging Systematic Risks with Index Options 255
Hedging Interest Rate Risk—Yield Curve Shifts 257
Hedging Volatility with Volatility Swaps 258
Hedging Omicron with Volatility Swaps 263
Hedging Omicron with Credit Default Swap Basket or Short Closed End Funds 265
Rough Spots for Convertible Arbitrage 266
Managing the Convertible Arbitrage Manager 271
Glossary 273
Index 289
