CONVERTIBLE ARBITRAGE: Defined

Posted on April 13, 2025 by Dr. David Edward Marcinko MBA MEd CMP™

By Staff Reporters

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Convertible Arbitrage

Convertible arbitrage is the oldest market-neutral strategy. Designed to capitalize on the relative mispricing between a convertible security (e.g. convertible bond or preferred stock) and the underlying equity, convertible arbitrage was employed as early as the 1950s.

Since then, convertible arbitrage has evolved into a sophisticated, model-intensive strategy, designed to capture the difference between the income earned by a convertible security (which is held long) and the dividend of the underlying stock (which is sold short). The resulting net positive income of the hedged position is independent of any market fluctuations. The trick is to assemble a portfolio wherein the long and short positions, responding to equity fluctuations, interest rate shifts, credit spreads and other market events offset each other.

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Hedge Fund Research (HFR) New York, offers the following description of the strategy

Convertible Arbitrage involves taking long positions in convertible securities and hedging those positions by selling short the underlying common stock. A manager will, in an effort to capitalize on relative pricing inefficiencies, purchase long positions in convertible securities, generally convertible bonds, convertible preferred stock or warrants, and hedge a portion of the equity risk by selling short the underlying common stock. Timing may be linked to a specific event relative to the underlying company, or a belief that a relative mispricing exists between the corresponding securities. Convertible securities and warrants are priced as a function of the price of the underlying stock, expected future volatility of returns, risk free interest rates, call provisions, supply and demand for specific issues and, in the case of convertible bonds, the issue-specific corporate/Treasury yield spread. Thus, there is ample room for relative mis-valuations.

Because a large part of this strategy’s gain is generated by cash flow, it is a relatively low-risk strategy. 

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MERGER ARBITRAGE: Risk Arbitrage Defined

Posted on March 30, 2025 by Dr. David Edward Marcinko MBA MEd CMP™

By Dr. David Edward Marcinko; MBA MEd CMP™

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Sponsor: http://www.CertifiedMedicalPlanner.org

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Merger Arbitrage (a.k.a. Risk Arbitrage)

Merger risk arbitrage, while a subset of a larger strategy called event-driven arbitrage, represents a sufficient portion of the market-neutral universe to warrant separate discussion.

Merger arbitrage earned a bad reputation in the 1980s when Ivan Boesky and others like him came to regard insider trading as a valid investment strategy. That notwithstanding, merger arbitrage is a respected strategy and when executed properly, can be highly profitable. It bets on the outcomes of mergers, takeovers and other corporate events involving two stocks which may become one.

Example:

A classic example is acquisition of SDL Inc. (SDLI) by JDS Uniphase Corp (JDSU). On July 10, 2010 JDSU announced its intent to acquire SDLI by offering to exchange 3.8 shares of its own shares for one share of SDLI. At that time, the JDSU shares traded at $101 and SDLI at $320.5. It was apparent that there was almost 20 percent profit to be realized if the deal went through (3.8 JDSU shares at $101 are worth $383 while SDLI was worth just $320.5).

This apparent mispricing reflected the market’s expectation about the deal’s outcome. Since the deal was subject to the approval of the U.S. Justice Department and shareholders, there was some doubt about its successful completion.

Risk arbitrageurs who did their homework and properly estimated the probability of success bought shares of SDLI and simultaneously sold short shares of JDSU on a 3.8 to 1 ratio, thus locking in the future profit. Convergence took place about eight months later, in February 2011, when the deal was finally approved and the two stocks began trading at exact parity, eliminating the mis-pricing and allowing arbitrageurs to realize a profit.

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Hedge Fund Research defines the strategy as follows:

Merger Arbitrage,also known as risk arbitrage, involves investing in securities of companies that are the subject of some form of extraordinary corporate transaction, including acquisition or merger proposals, exchange offers, cash tender offers and leveraged buy-outs. These transactions will generally involve the exchange of securities for cash, other securities or a combination of cash and other securities. Typically, a manager purchases the stock of a company being acquired or merging with another company, and sells short the stock of the acquiring company. A manager engaged in merger arbitrage transactions will derive profit (or loss) by realizing the price differential between the price of the securities purchased and the value ultimately realized when the deal is consummated. The success of this strategy usually is dependent upon the proposed merger, tender offer or exchange offer being consummated.

When a tender or exchange offer or a proposal for a merger is publicly announced, the offer price or the value of the securities of the acquiring company to be received is typically greater than the current market price of the securities of the target company. Normally, the stock of an acquisition target appreciates while the acquiring company’s stock decreases in value. If a manager determines that it is probable that the transaction will be consummated, it may purchase shares of the target company and in most instances, sell short the stock of the acquiring company. Managers may employ the use of equity options as a low-risk alternative to the outright purchase or sale of common stock. Many managers will hedge against market risk by purchasing S&P put options or put option spreads.

Cite: https://www.hfr.com See § 23.03[E].


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Appreciating Post Cyber Monday Stock Market Volatility

Posted on November 27, 2017 by Dr. David Edward Marcinko MBA MEd CMP™

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Living with Ambiguity [Is it Friend or Foe?]

By Robert Klosterman CFP® http://www.whiteoakswealth.com/

The stock market was down a bit last month and up last week, and then down today; back and forth, rising and falling and rising again the last few years, etc, etc.

Now: 23 557 DJIA

Whipsaw is the word I’ve heard to describe it lately. And, without a doubt, the question that gets asked the most is “How do you like this volatility?”

My reply, without exception, is “I LOVE volatility. I do prefer upside volatility to downside though”. The response is a smile or an outright laugh. Of course, few physicians or laymen I have ever met get worried about upside price movements in investing.

Third Quarter 2017

The third quarter of 2017 – post election results – clearly experienced both major up and downside volatility with the recent emphasis on the upside. Investors that fully invested in equities saw their portfolios rise in the positive and record-breaking direction.

Europe

The market pundits have a daily hero to pin the market movements on. Europe, Syria, Russia and Putin, Turkey, Greece, US Congress stalemates and other forces like the death of Fidel Castro are some of the most recent “good guys” that have given rise to Mr. Market’s positivity. Did we mention  Donald Trump?

How Long?

The bigger question is how long will these issues persist? Established societies, often described as western economies, have some significant headwinds facing them for the next few years: high debt, mounting costs of social insurance programs, and the likelihood of higher taxes to solve the problems.

There is nothing new or unique about that last sentence. There seems to be a wide consensus on those points and coupled with the record low interest rates, investors seem to have few traditional options to consider. It appears likely that it will take a few years to resolve these issues and provide a platform for above average growth.

Strategies

There are a number of strategies that can utilize volatility including Long-Short, Mean Reversion, Managed Futures and Market Neutral, etc [previously noted on this ME-P]. These provide returns in a secular bear market that may continue for a few more years.

Link: https://medicalexecutivepost.com/2007/11/28/what-is-a-market-neutral-fund/

It’s also important to recognize that while the US and Western Europe maybe having to face the headwinds there are economies in parts of the world that will likely experience above average growth rates for the next few years. For the most part, these emerging markets include Brazil, Russia, India and China (BRIC). A strong dollar not-withstanding.

BRIC Analogs to the USA

In the 1870‘s, the US was an emerging market the same way the BRIC economies are today’s emerging markets; developmentally analogous. Whereas the US and Western Europe face many headwinds, some of these emerging economies actually have wind in their backs. Trade surplus, demographics, low debt and low cost of Government are some of the key advantages. These countries’ standard of living is changing to the positive, and they have a large percentage of their population that can move up and be a purchaser of goods and services where previously they could not.

Income Generation

Another important focus will be on income generation. For many years the income portion of an investment in equities was half or more of its return. Only in recent years has the largest portion come from capital gains. We are likely “back to the old days” in order to achieve returns that will offset inflation and meet longer-term investment goals

Opportunities exist in a variety of areas, including real estate, Mortgage Backed Securities, Private Equity and others to have more focus on income as a dominant portion of the total return.

Assessment

Volatility is going to be with us and it would be wonderful to have the confidence needed to say the emphasis would be on upside volatility, but that is not the case right now. The optimum strategies are to align portfolios with the world we live in today.

IOW: Doctors, medical professionals and all investors must learn to “live with ambiguity.”

About the Author

Robert J. Klosterman® has been listed as one of the Top 250 Financial Advisors in the United States by Worth Magazine. He has also been recognized as one of the top 150 Financial Advisors by Mutual Fund Magazine, Medical Economics and Bloomberg’s Wealth Manager Magazine. Bob’s published quotes appear frequently in dozen’s of local and national publications, including USA Today, the New York Times, Minneapolis Star Tribune, CFP Today, Barron’s and Fortune.

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