Market Efficiency and Returns from Convertible Bond Hedging and Arbitrage Strategies

Abstract

This article explores the returns of convertibles as well as the returns of a large array of convertible hedging and arbitrage strategies. Market efficiency tests are performed using various portfolios that comprise opposite long bonds and short underlying equity positions, the returns and risks of convertible bond convergence hedging portfolios, and combinations of convertible bonds, corporate bonds, and options of the same issuer. Hedged positions based on the characteristics of the bonds are shown to provide superior absolute and relative returns. A bullish gamma hedging strategy put on at the time of the issuance of the convertibles and a delta-neutral strategy with larger delta change tolerance are shown to be particularly advantageous. These trading strategies are found to be robust to alternative specifications of transaction costs, leverage effects, and alternative parameter inputs. In summary, market commentators who predict the demise of such opportunities may be wrong.