Convertible Pricing from CDS

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I am doing a research project on convertible bonds issued by french companies in USD (mostly between 2016-2018).
I have been told that it was done as there was an arbitrage in the pricing as hedge funds would price the instrument by looking at the CDS instead of the interest rate curve applicable to the firm.
How is the pricing using CDS done in practice?

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Comments (11)

 
Apr 6, 2020 - 5:24pm

i work in levfin and done an extensive project about cbonds during my academic years. PM me with what you exactly need to know. Cbonds can be slightly more illiquid compared to the usual flavours of fixed income instruments, so hedge funds do not turn a big profit by flipping cbonds. Instead, convertible bond arbitrage is what hedge funds usually perform. I can tell you all about that. If you actually looking to get into the mathematics, like what model can be used to value cbonds, e.g. CDS as a measure of credit default, i can also help you with this.

 
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Apr 6, 2020 - 7:36pm

I can assure you as someone who has traded CBs and managed a portfolio of them, HFs most certainly make significant PnL on flipping new issue CBs.

It may go something along the lines of this.

  1. New issue comes out (let's assume terms have already been set and there hasn't been a wall-crossing). It is not garbage (hopefully), is of big enough size, in the right industry and so will be included in the CB index. This means that long only funds, which are about 70% of the market and bench-marked to said index need to hold the paper.

  2. Everyone puts in orders.

  3. Now the grey markets come into play (at least internationally). Banks not on the deal want a piece of action for their clients and/or their inventories. HFs and banks trade with each other. Some funds flip in the grey markets, some don't (different topic for different thread). NOTE: ALLOCATIONS HAVE NOT COME OUT YET.

  4. Overnight/later in day post close - Allocations go out. It is not rare that the long only guys get less than they should and hedge funds get more (especially big funds that trade a lot and/or run size). Why? They are a huge source or revenue for the desk/bank. These funds not only trade more (ie. so the desk makes more spreads by volume), they lever more (ie. prime brokerage makes money), use more stock borrow facilities (stock borrow guys in prime make money), and they hedge more (ie. equities trading gets more flow as do options guys and cds folks). Whereas long only funds may be size holders, but don't trade much, don't use leverage or hedge.

  5. Pre-market. Hedgies put in orders to short the requisite amount of stock to hedge out their (usually equity) risk. Stock moves lower as a result of increased volume due to short selling.

  6. Market opens. Long only funds chase the paper since, well, they need to get their desired allocation in the portfolio to chase the index (or what will be in the index at the end of the quarter). Long only funds are most of the market. Simplistically speaking, that demand causes prices to go up (yes even with equity down or flat - this is called vol richening).

  7. Hedgies sell some or all of their paper at a very low risk profit to the bank (often the one bringing the deal). Bank then sells said paper to long only and makes a nice spread (market making). Everyone but the long only profits. Long only is annoyed but knows what is going on.

The key is allocation and ability to get it. The number of people at large hedge funds who literally make a very significant amount of their PnL from new issue flipping would surprise many on this board. In fact there are some guys in HFs who will literally trade volume daily (like a market maker) in order to be first call for a bank when a new deal comes out. Sound simplistic, stupid and way too easy (and unworthy of whatever target school/engineering/cs whatever degree etc?) Maybe. But that's the game.

I hope this helps.

Good Luck

I used to do Asia-Pacific PE (kind of like FoF). Now I do something else but happy to try and answer questions on that stuff.
 
Apr 11, 2020 - 6:54am

Great reply Jamoldo . Rarely see these kind of insightful comments on here. The information you provide is something that can't be found in academic papers etc.

I have a number of questions, perhaps you are able to able to answer (some of) them.

  1. In terms of the delta neutral hedging, how long would you say HF's tend to be in the convertible bond? For example, a couple weeks, a couple months?

  2. Would you say the delta neutral hedging causes short sell levels to be significantly higher for this (delta-hedging period) period?

  3. If your answer for question 2 is 'yes'; Would you expect delta hedging to be higher for convertible bonds for which the convertible bond's embedded option's gamma is higher.

  4. For hedgies that stay in the CB for a longer period, one source of income would be interest rebate (correct?). How significant would that source of income be nowadays, with interest rates at these low levels.

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