What strategy does a convertible arbitrage hedge fund employ?

Convertible arbitrage hedge funds specifically look to exploit price discrepancies between convertible bonds and the underlying equity of the issuing company. The strategy involves taking long positions in convertible bonds, which provide the opportunity for capital appreciation when the underlying stock rises, as these bonds can be converted into shares at a predetermined price.

Simultaneously, the hedge fund will take short positions in the underlying stock. This short position serves to hedge against the market risk associated with holding the convertible bonds. By doing so, the fund can protect itself from losses in the event that the stock price decreases. The objective is to capture the "arbitrage" profit from the mispricing between the equity and the convertible bond.

This strategy effectively allows the hedge fund to minimize its exposure to market fluctuations while still allowing for profit potential from the movements of the underlying stock price relative to the convertible bonds. Overall, this combination seeks to ensure that the hedge fund can realize gains regardless of the direction of the broader equity market, as long as the relative pricing between the two securities is favorable.