Convertible Bond Arbitrage and the Term Structure of Volatility

27 Pages Posted: 24 Jan 2021

See all articles by Peter Zeitsch

Peter Zeitsch

FactSet

Matthew Hyatt

FactSet

Tom P. Davis

FactSet Research Systems Inc.

Xi Liu

FactSet Research Systems Inc.

Date Written: November 30, 2020

Abstract

A mark-to-market approach for convertible bonds is proposed where the volatility from the bond optionality is implied from the traded credit spread and bond price. By linking the convertible bond implied volatility to the listed equity option implied volatility surface, the set of available tenors is significantly extended. The resulting volatility term structure classifies rich versus cheap bonds. Convertible bond arbitrage trades, where the trader buys the bond and hedges a combination of the underlying assets, are subsequently identified. Each bond’s relative cheapness translates to its arbitrage potential as a long volatility position, as shown through case studies.

Keywords: Convertible Bond Arbitrage; Implied Volatility Term Structure; Long Vega; Long Omicron.

JEL Classification: C32; C53; G11; G12.

Suggested Citation

Zeitsch, Peter and Hyatt, Matthew and Davis, Tom and Liu, Xi, Convertible Bond Arbitrage and the Term Structure of Volatility (November 30, 2020). Available at SSRN: https://ssrn.com/abstract=3740111 or http://dx.doi.org/10.2139/ssrn.3740111

Peter Zeitsch (Contact Author)

FactSet ( email )

601 MERRIT 7 #3
NORWALK, CT 06851
United States

Matthew Hyatt

FactSet ( email )

601 Merritt 7, 3rd Floor
Norwalk, CT 06851
United States

Tom Davis

FactSet Research Systems Inc. ( email )

601 MERRIT 7 #3
NORWALK, CT 06851
United States

Xi Liu

FactSet Research Systems Inc. ( email )

181 W Madison St
33rd Floor
Chicago, IL 60602
United States

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