Convertible arbitrage is a market-neutral investment strategy that seeks to capitalize on valuation discrepancies between a convertible security and its underlying common stock. In the crypto domain, this principle extends to financial instruments convertible into a base digital asset, aiming to profit from price inefficiencies while hedging directional market risk.
Mechanism
The strategy involves simultaneously purchasing a convertible bond or token and selling short the equivalent value of the underlying common stock or base digital asset. This dual position aims to offset general market movements, isolating the profit potential from the convertible’s embedded option value and any credit spread dynamics. Traders manage delta exposure through dynamic hedging to maintain market neutrality.
Methodology
This approach relies on sophisticated quantitative models to assess the fair value of the convertible instrument, considering its equity option and fixed-income components, alongside implied volatility. Practitioners employ dynamic delta hedging to adjust the short position in the underlying asset as its price fluctuates, aiming to consistently capture arbitrage opportunities arising from pricing dislocations between the convertible and its common stock equivalent.
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