Convertible Bond Risk Framework

This paper presents a framework for calculating fair value and risk of convertible bonds. A typical convertible bond arbitrage employs delta-neutral hedging, in which an arbitrageur buys a convertible bond and sells the underlying equity at the current delta. Delta neutral hedging not only removes small directional risks but also is capable of making a profit on an explosive upside or downside breakout if the position’s gamma is kept positive. As such, delta neutral hedging is great for uncertain stocks that are expected to make huge breakouts in either direction. Since convertible bonds are issued mainly by start-up or small companies, the chance of a large movement in either direction is very likely. Even for very small movements in the underlying stock price, profits can still be generated from the yield of the convertible bond and the interest rebate for the short position.https://ia600706.us.archive.org/29/items/pricingConvertibleBond-fp/pricing-convertible-bond-3.pd