Convertible Arbitrage funds study the relationship between a company’s stock and its convertible bonds. Convertible bonds contain an option that allows the bondholder to trade in the bond for common stock at a certain price and under certain conditions. Usually, the bond trades for less than the stock so managers buy the bond and short the stock. These funds craft strategies to manage their exposure to interest rate risk, default risk, and illiquidity in the convertible bond market, and pricing volatility in both the stock and bond markets. Because the pricing discrepancies are usually very small, many of these funds employ leverage to maximize return.
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