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Convertible arbitrage is one type of investment approach that involves two simultaneous moves on investment options with a given company. Often, the most common approach to a convertible arbitrage will mean assuming a long position on a convertible security issued by the company, while at the same time assuming a short position on the underlying common stock. The purpose of the use of convertible arbitrage is to take advantage of a market situation where there is a perception that the securities are priced lower than conditions merit.
The implementation of a convertible arbitrage begins with buying convertible securities. These convertible securities may be in the form of a bond issue, but offer the chance to convert the bond into shares of common stock at some future point. Buying the convertible securities places the investor in a position to hold on to the security as is, or take advantage of a conversion at a pre-determined price in the event there is anticipation that the stock will rise in value in the short term.
At the same time, the process for a convertible arbitrage also involves selling any underlying equities associated with the company. This arrangement further helps to reinforce the position of the investor, since there would be a perception that the acquired securities were currently being undervalued. When the perception is corrected, the investor is left holding securities that are substantially more valuable than they were at the time of purchase. However, if it turns out the convertible securities were not undervalued after all, the loss will still be somewhat minimal in most cases.
Because there are usually some restrictions on the time frame required before stock conversion can take place with convertible securities, it is important for the investor to evaluate the situation very carefully before beginning the creation of this dual long and short position. Doing so will help to determine if market situations will coincide with various points in time where the security can be converted and thus take advantage of an upswing in value of the shares of stock received as a result of the conversion.