What is a cash flow arbitrage strategy involving convertible bonds?
What will be an ideal response?
The cash flow from a convertible bond differs from the cash flow from a stock. The idea behind a cash flow arbitrage strategy is to create equivalent positions in the convertible bond and underlying stock so that any additional cash flow available from the convertible bond can be captured while eliminating or mitigating any risks. More specifically, the convertible bond is purchased with funds obtained from shorting the underlying stock.
In convertible bond arbitrage trades, typically a long position is established in the convertible bond, and simultaneously, a short position is established in the underlying stock. The number of shares shorted is such that any change in the value of the convertible bond will be equal to the change in the position of the stocks shorted. This is determined by the delta of the convertible bond, and the resulting position is said to be market neutral.
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