Liquidity provision in the convertible bond market: analysis of convertible arbitrage hedge funds

This paper analyzes the risk and rewards of providing liquidity to the convertible bond market. Using daily data on US and Japanese convertible bonds (CBs), we compute returns to a buyandhedge arbitrage strategy involving a long position in CBs while hedging the equity, credit, and interest rate risks. We find that this simple strategy can explain a large proportion of returns earned by convertible arbitrage (CA) hedge funds. We also show the importance of incorporating discrete exogenous shocks such as market disruption events and abnormal changes to the convertible arbitrageur’s opportunity set such as imbalances between supply and demand for CBs. Finally, we demonstrate that the alphas of CA hedge funds can be explained by the original issue discount in the primary CB market. Overall, the empirical findings are consistent with the notion that arbitrageurs act as liquidity providers to the CB market