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KBC Alternative Investment Management: Convertible Bond Arbitrage Executive Summary Case Solution & Answer

KBC Alternative Investment Management: Convertible Bond Arbitrage Executive Summary Case Study Help

Introduction

A convertible arbitrageur at KBC AIM – Mart Punt, has been engaged in buying the bonds and delta hedging those bonds with the short position, in the shares of the company with core consideration of extracting the cheap volatilityin the Duke Energy’s convertible bonds. In order to effectively manage the credit risk of this long position in convertible bonds; Mark is now facing the choice either hedging with the 5 year credit default swap (CDS), out of the money or putting the shares of the company in its stock. One of the keys of this type of hedging strategy is having an in-depth knowledge and understanding of the observed negative correlation between the share price of the Duke Energy and credit spreads.

How many shares does Mark need to short to establish his delta-neutral position? In what direction will he have to adjust his short equity position as the share price increases? As the share price decreases?

It is notable that the delta of the underlying stock, typically a stock position, is -1 if the position is short position. Establishing a delta neutral position is significantly important due to the projection of declinedstock prices in the short position. The number of shares that Mark would need to short, requires the determination of kind of delta neutral hedge. To calculate the number of share needed; it is assumed that the company would be required to produce 100 deltas, and both at the money call options and put options have 0.5 delta value. The number of shares are calculated by dividing 100 deltas by the delta value of both at the money call option as well as the put option, hence resulting in 200 shares. Hopefully, the company could enjoy the profit when the short sales stock get reduced but if they don’t reduce then the company would lose money on the short sale position, and would need to purchase the stock back as well as repay the loan.(Dorian, 2016).

Assuming Mark puts on this delta-neutral position, the implied volatility of the convertible doesn’t move, but the share price immediately jumps by $1, what happens to the total value of the position if

The jump is upward

With the assumption that Mark puts on his delta-neutral position; the implied volatility of the convertible bond does not move but the price immediately jumps upward by 1 dollar.The total value of the position would increase and the position would profit in case if the share price increase due to the reason that the value of the stock would be increasing by the amount of the increase in the stock price.

The jump is downward

With the assumption that the Mark put on his delta-neutral position; the implied volatility of the convertible bond does not move, but the price immediately jumps downward by 1 dollar, and the total value of the position would maintain its value and neither does it decrease nor increase in the price. It is due to the fact the position is constructed that do not react to the changes in the price of the underlying stock.

What are the main sources of profit in Mark’s convertible arbitrage strategy? Under what conditions is the strategy therefore likely to prove most/ least profitable?

A convertible arbitrageur at KBC AIM – Mart Punt has been engaged in exploiting the mispricing between the underlying equity of the firm and the convertible bonds, which means that the company identifies cheaply trading convertibles – low implied equity value in relation to the historical volatility. The information provided in the case shows that the company launched first investment vehicle as a convertible arbitrage fund and convertible opportunities fund. The return of the first convertible arbitrage fund was 9.5 percent ,and the convertible opportunities fund returned 23 percent in its year. The sources of the company’s revenue generation is the cheapness of the convertibles as well as the position against the changes in the value caused by the significant movement in the price of the underlying asset. Additionally, the convertible arbitrage helps the company to capitalize on the inefficiencies of the pricing between stock and convertibles……………………………………..

 

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