The convertible bond arbitrage manager can create a portfolio that acts like a normal bond. They establish a long position in convertible bonds and a short position in the equity of the bond issuer. A convertible bond is a bond that has an option for the owner to exchange the bond for stock from the issuer. The short equity position should be equal to the long convertible position. The long position is equal to the amount of stock converted multiplied by a factor - called delta or hedge ratio. This factor changes constantly and causes the fund manager to adjust their equity position frequently.
The fund has several sources of return:
- Change in convertible bond price - If the bond's price rises, then the return increases
- Change in stock price - If the stock's price falls, then the return increases
- Convertible bond's coupon - Interest paid from the bond increases the return
- Short rebate - Interest earned on capital from short stock position increases the return
- Interest paid on borrowed capital - Fund manager pays interest on borrowed funds, reducing the return
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