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 (?) 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