Convertible Bond Conversion Arbitrage
A convertible bond can be swapped for stock at an agreed price. When the stock jumps and the convertible lags, buy the convertible, convert, and sell the stock to pocket the gap, as long as you lock away the overnight risk.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
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Text version · Arbitrage Strategies, lesson 10: “Convertible Bond Conversion Arbitrage”
A convertible bond can be swapped for stock at an agreed price. When the stock jumps and the convertible lags, buy the convertible, convert, and sell the stock to pocket the gap, as long as you lock away the overnight risk.
Convertible bond = bond + conversion right
A convertible bond can be converted into stock at the conversion price. When the stock is low it acts like a bond, supported by the bond floor; when the stock is high it rises with the conversion value. Normally it's a bit more expensive than both.
Cheaper than the stock? Convert and sell
When the stock jumps, the convertible sometimes fails to keep up, and the conversion premium turns negative. Buy the convertible, convert, sell the stock, and the discount minus costs is profit: this is conversion arbitrage.
Lock away the overnight risk first
In China's A-share market, shares from a conversion only arrive the next day, and a drop in the stock overnight can eat the discount. Borrowing shares and selling the same amount at the same time locks in today's sale price, which gets close to risk-free, but borrowed shares aren't always available, and they cost a fee.
Key takeaways
- Conversion value = face value ÷ conversion price × stock price; conversion premium = convertible price ÷ conversion value − 1.
- When the conversion premium is negative and the discount exceeds your costs, buy the convertible, convert and sell the stock for a profit.
- In China's A-share market, converted shares arrive the next day. Unless you borrow shares to lock in the selling price, you carry the stock's overnight risk.
- Normally a convertible trades above both its conversion value and its bond floor; a negative premium usually appears only briefly when the stock jumps.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click "Example: stock $12 · premium −1.25%": what are the conversion value and the convertible quote? After locking in by borrowing shares, how much does each bond make? How much for 1,000 bonds?
- Switch to "Sell the next day" and keep the next-day stock move at −3%: what's the P&L per bond? How far does the stock have to fall overnight to wipe out the discount?
- Switch back to "Borrow and lock in the same day" and drag the premium to −0.25%: does each bond still make money? How many dollars of discount do you need, at least, to cover costs?
- Drag the stock to $7 with a +5% premium: what's the convertible quote? Where does the purple illustrative curve say it should normally be? Why?
Quiz and explanations
- 1. A convertible has a $100 face value and an $8 conversion price, and the stock is $10. What's the conversion value?
- Answer: $125.Each bond converts into $100 ÷ $8 = 12.5 shares, × $10 = $125.
- 2. The convertible is quoted at $123, its conversion value is $125, and trading plus borrowing costs total $0.5 per bond. After locking in with borrowed shares, how much do you make per bond?
- Answer: $1.5.$125 − $123 − $0.5 = $1.5.
- 3. If you don't borrow shares and instead wait to sell the converted shares when they arrive the next day, what's the biggest risk?
- Answer: The stock falls overnight, wiping out the gap or even causing a loss.The selling price wasn't locked in ahead of time, so it's no longer risk-free arbitrage.
Terms in this lesson
- borrowing shares (Borrow): Before shorting, you borrow shares from your broker, and you must eventually buy back the same number to return them.
- convertible bond (Convertible Bond): A bond that can be swapped for company shares at an agreed conversion price: bond-like when the stock is low, with principal and interest as a floor, and stock-like when it's high.
- bond floor (Bond Floor): What a convertible is worth as a plain bond (discounted at the yield of similar-credit bonds); however far the stock falls, the convertible usually doesn't drop much below it.
- conversion premium (Conversion Premium): How much more the convertible costs than its conversion value = convertible price ÷ conversion value − 1; when negative, buying the convertible and converting is cheaper than buying the stock, opening a possible arbitrage.
- conversion price (Conversion Price): The agreed price per share when converting; a convertible with $100 face value and a $10 conversion price converts into 100 ÷ 10 = 10 shares.
- conversion value (Conversion Value): The value of the shares one convertible would get if converted right now = shares received × stock price.