Convertible Bond Arbitrage: Risk and Return

Authors

  • Mark C. Hutchinson,

    1. The first author is Co-Director at the Centre for Investment Research and Finance Lecturer at University College Cork. The second author is Professor of Finance at Dublin City University and Visiting Professor at Cass Business School, City University, London. The financial support of the Irish Research Council for the Humanities and Social Sciences (IRCHSS) is gratefully acknowledged. Liam Gallagher would also like to acknowledge the financial support of Science Foundation Ireland (Project No. 07/MI/008). The authors are also grateful to Sungard Trading and Risk Systems for providing data and software and Kenneth French, Øyvind Norli, Vikas Agarwal, Narayan Naik and Ĺubos Pastor for generously providing data. They also thank Lucio Sarno, Vincent O’Connell, Niall O'Sullivan and the Editors for their comments.
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  • Liam A. Gallagher

    Corresponding author
    1. The first author is Co-Director at the Centre for Investment Research and Finance Lecturer at University College Cork. The second author is Professor of Finance at Dublin City University and Visiting Professor at Cass Business School, City University, London. The financial support of the Irish Research Council for the Humanities and Social Sciences (IRCHSS) is gratefully acknowledged. Liam Gallagher would also like to acknowledge the financial support of Science Foundation Ireland (Project No. 07/MI/008). The authors are also grateful to Sungard Trading and Risk Systems for providing data and software and Kenneth French, Øyvind Norli, Vikas Agarwal, Narayan Naik and Ĺubos Pastor for generously providing data. They also thank Lucio Sarno, Vincent O’Connell, Niall O'Sullivan and the Editors for their comments.
      * Address for correspondence: Mark Hutchinson, Department of Accounting, Finance and Information Systems, University College Cork, College Road, Cork, Ireland.
      e-mail: m.hutchinson@ucc.ie
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* Address for correspondence: Mark Hutchinson, Department of Accounting, Finance and Information Systems, University College Cork, College Road, Cork, Ireland.
e-mail: m.hutchinson@ucc.ie

Abstract

Abstract:  This paper specifies a simulated convertible bond arbitrage portfolio to characterise the risks in convertible bond arbitrage. For comparison the risk profile of convertible bond arbitrage hedge fund indices at both monthly and daily frequencies is also examined. Results indicate that convertible bond arbitrage is positively related to default and term structure risk factors. These risk factors are augmented with the simulated convertible bond arbitrage portfolio, mimicking a passive investment in convertible bond arbitrage, to assess the risk and return of individual hedge funds. We provide estimates of the performance of two hedge fund indices (an equally weighted and value weighted index) and a sample of convertible bond arbitrage hedge funds using a factor model methodology. Lagged and contemporaneous observations of the risk factors are specified, controlling for illiquidity in the securities held by funds. Our results cover two time periods. Initially we find evidence of abnormal risk adjusted returns in the individual hedge fund data and the equally weighted hedge fund index and no evidence of abnormal risk adjusted returns in the value weighted hedge fund index. When we examine performance during the credit crisis of 2007 and 2008 we find evidence of negative abnormal returns amongst individual hedge funds and the hedge fund indices.

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