Convertible Arbitrage: Insights and Techniques for Successful Hedging

i studied from this book for the CAIA exam. while it presented some very fascinating approaches and ideas for me, keeping in mind i am not a practising arbitrageur yet, it was very poorly edited and written in general.

every book starts with an assumption about the level of sophistication the reader. this book seems to assume different levels in different chapters and even paragraphs. the chapter on equity valuation is written for kids (lose the chapter, nick) and the ones on hedging techniques doesn’t even bother to list assumptions behind complex positions.

the author uses the most confusing notations. e.g. Nu-1, literally typed out like that, which is supposed to represent a variable with subscript u-1. geez – whatever happened to computer typesettng with actual subscripts, and why use the same notation for different variables in different formulae? at least he could have used Nu-1 and Mu-1. I spent a lot of time making sense out of this one and assumed he was referring to Nu minus 1!

basically, if the same ideas were carefully thought out and presented by better editing and writing (and typesetting!), this would be an enjoyable book. as it stands, its a torture to go through. such wonderful ideas and such poor presentation. this one went out the door too early.

To successfully employ convertible arbitrage, you need to value convertible bonds (CBs) correctly to be able to find underpriced CBs to buy, and then you need to know the number (delta) of stocks to short sell to hedge your position. How do you do this? The book correctly tells you that a binomial method must be used, but it spends only 10 pages or so on this matter! And even if you are proficient with binomial valuation, this description is quite poor and confusing. Most important though, the book does NOT cover the more complex attributes of convertible bonds (such as call and put provisions) that are very common. How can you expect to find underpriced CBs if you don’t value them properly? If you truly want to learn convertible arbitrage, I instead recommend the book “Pricing convertible bonds” by Kevin Connolly who carefully explains all the things you need to know about the valuation of CBs, so that even if you have never heard about binomial trees you will still understand it (he also supplies a disc with excel files).

This is by far one of the best books on hedge fund strategies. It’s very practical, but also provides enough technical details. Most other books on hedge funds just state some basic facts that everybody knows. This book, however, provides enough details on one single strategy, convertible arb. I would highly recommend this book to any serious Quant who wants to know more about convertible arb.

This is no book for beginners, as I have a background in economics, econometrics, and trading, but I find the prose jumps over and casually breezes past assumptions, leaving me thinking I must have missed something. In almost each sentence and paragraph you have to absorb and absorb and keeping trying to figure out the author’s angles on what he means. Currently I am on pages 139-140, and I find impatience when encountering one-time blithe statements like “In practice, some slight additions to the short position on the way up will lock in some gains and avoid a hedge ratio that is extremely low relative to the delta.” Or, “The hedge ratio on a leveraged bullish tilt position should generally be slightly more than the hedge ratio on the un-levered bullish tilt position to reduce some of the added volatility in the return.” The syntax while trying to be plain language, loses the reader. I keep asking what exactly is “generally be slightly more than the hedge ratio” mean in the context of a portfolio; and do you own one each of the levered and unlevered to reduce volatility, and if not how can I be so confident my hedge ratio is thus adjusted properly if the volatility is well, volatile? It is like he writes to impress, which is not a bad thing by itself. It’s clear he’s having a good time. But if read aloud at a conference of CEO’s, I can envision them nodding their heads and furrowing their sagacious brows without actually a full understanding of what is said.

So the prose is dense. But it eventually “sounds” right to the ear if read over a couple times quickly, but still loaded with very subtle ideas watered down into plain words which can makes me stop and pause to consider each idea as if it were some kind of rosetta stone to the prior material. At the same time it gets me to pause and think, which is an upside and rewards patience. But it’s getting harder to gauge at this chapter how much progress I have made or not made, but I optimistically press on. I keep it hand so I can have more chances to peek inside this mysterious veil of conv arb. and learn something new and interesting.

It would be helpful to have more specific details where a natural question of ‘why?’ occurs if asked by a reader. From my own perspective, formulas would be far more compact and precise in conveying these ideas. English studies or philosophy enthusiasts may find it an enjoyable challenge to discern the Da Vinci-code like meanings.

I am not saying this is not a good book. In fact, this is by far the best I had come across on Convertible Arbitrage. It’s so informative and well written that it should be a handbook for hedge fund professionals or finance professors. However, it’s far beyond the comprehension of the investment public who would surely be confused by the vast amount of greek alphabets, financial equations and graphs. Of course, for those affluent readers (time- and money-wise) who want to learn, say, Bearish Tilt Gamma Convertible Hedge, Vega Hedge thru Volatility Swap etc. despite the technicalities and scale issues facing individual investors, it’s definitely not a bad bet.