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Chapter 6 - Convertible Bond Arbitrage > 6.10 RISK CONTROL
6.10 RISK CONTROL
All the components of a convertible bond represent an investment opportunity but also a risk: credit, interest rates, the equity component and volatility.
Interest rates stand for the cost of capital: when interest rates go up, investors will be attracted by higher interest rates and the value of the debt issued at lower rates will go down. Hence, an increase in interest rates will cause a decrease in value of the bond component of a convertible bond.
Hedge fund managers can hedge against the risk of an interest rate rise by using interest rate futures, forwards and interest rate swaps. They can also hedge against the issuer default risk by buying credit default swaps.
Let’s analyze the main risks to which convertible bond arbitrage is exposed:
1. Equity market risks. If the hedging is not equity market-neutral, the arbitrage is exposed to the risk of market fluctuations.
2. Interest rate risk. The convertible price moves in an inversely proportional manner with respect to the changes in interest rates, and the closer the convertible trades to its bond floor, the higher its interest rate sensitivity is. A rise in interest rates decreases the value of convertibles, but usually an interest rate hike is bad news for equity markets, therefore a short position on the underlying stock should act as a protection against interest rate rises. The value of the option embedded in the convertible grows as the interest rate grows, and therefore it provides a further hedge against interest rate rises, because when the value of the underlying stock decreases, the option to convert into a fixed number of shares becomes mor....
3. Credit risk. Risk of widening credit spreads. The short position on the underlying stock partly reduces this risk because when credit spreads widen, share prices go down. Arbitrageurs can hedge against the risk of spread widening by buying a credit default swap.
4. Leverage is often used to amplify returns, but it can significantly increase risk.
5. The risk of special events, like a dividend payout. If the company pays a dividend, the fund manager who is short the company’s stock must pay the amount of the dividend to the counterparty from whom he borrowed the stock. So the hedge fund manager who is delta hedging is exposed to the risk that the company pays a dividend. This risk may increase as a result of regulatory or fiscal changes: an example we mentioned when tackling short selling is the US “Jobs and Growth Tax Relief Reconciliation Act” in May 2003.
6. Liquidity risk. The risk that the bid/ask spread on the convertible bond and the share widens. This may be particularly true for securities of companies with a low creditworthiness. The liquidity risk is higher for small convertible issues. Arbitrageurs cannot hedge against this risk.
7. Short selling exposes the risk of a short squeeze, namely a sudden call for the shares to be returned.
8. A shortage of borrowable shares may prevent the fund manager from establishing the hedge.
9. The prospectus of some issues may contain provisions that give the issuer the right to:
• force the bond conversion in case the conversion of a given percentage of the total convertible bond issue is called (clean-up call);
• force the bond conversion in case the stock dividend yield falls below the interest rate paid by the convertible (provisional call);
• be exempt from paying accrued interest on bonds in case the bond holder exercises the conversion right (screw clause).
10. Currency risk. This happens when the portfolio is diversified across multiple currencies. The fund manager can hedge against these risks with a forward contract.
