Fi (convertible arbitrage)

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Sunday, July 11, 2010


Susanny’s Final Presentation in SMU...


FNCE204: Analysis of Fixed IncomePrepared for Prof Thong Tiong Yang

Chris Tan Kok Yong | Kumara Velan S/O Suppiah | Kwok Kin Fei | Leonardi Susanny

A presentation by TY ‘Da Vinci’ Thong Fund...


WHAT’S THE AGENDA?


WHAT’S THE AGENDA?

Introduction to Convertible Bonds

Convertible DebtArbitrage Techniques

Risks Exposure

The ‘Da Vinci’ Code


INTRODUCTION TO CONVERTIBLE BONDS

Con

vert

ible

Bon

ds



A type of bond that allows holder to convert into shares at

conversion price

Con

vert

ible

Bon

ds



3 outcomes of a convertible bond

At the money

In the money

Out of the moneyCon

vert

ible

Bon

ds


WHY ISSUE CONVERTIBLE BONDS?

Con

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ible

Bon

ds


WHY ISSUE CONVERTIBLE BONDS?

Minimize negative investor interpretation

Less equity dilution compared to rights issue

Lower fixed-rate borrowing costs

Increase total level of debt-gearing

1 2

3 4

Con

vert

ible

Bon

ds


INTRO TO CONVERTIBLE DEBT ARBITRAGE

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ible

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Exploit mispricing in convertible bonds (CB)

21 French CBs were underpriced by 3%

103 US listed CBs were undervalued by 4%

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vert

ible

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ds



Exploit mispricing in convertible bonds (CB)

A result from the difficulty in valuing option

To price attractively to ensure demand

Con

vert

ible

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ds


NUMERICAL EXAMPLE

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ible

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NUMERICAL EXAMPLE

5% Coupon Rate, Annually1 year maturity

Convertible Ratio of 50 ABC shares ($20)Short 25 ABC shares

Share Price Unchanged Share Price Rise to $30 Share Price Drop to $10

Profit from Conversion $0 $500 $0

Profit/Loss from Short Sale $0 -$250 $250

Coupon Received $50 $50 $50

2% Interest from Short Sale $10 $10 $10

1% Interest to Broker -$5 -$5 -$5

Profit $55 $305 $305

% return 5.5% 30.5% 30.5%Con

vert

ible

Bon

ds


Convertible Debt Arbitrage Techniques

DELTA NEUTRAL HEDGE

GAMME CAPTURE HEDGE


DELTA NEUTRAL HEDGE

Arb

itrag

e Te

chni

ques


DELTA NEUTRAL HEDGE

Long Convertible Bond

Short Underlying Stock at current Delta

Delta ( )CVS

=

Arb

itrag

e Te

chni

ques


DELTA NEUTRAL HEDGE


Short Underlying Stock at current Delta

Delta ( )CVS

=

Yield no profit or loss from stock price movement

Capture cash flows from coupon and interest

Arb

itrag

e Te

chni

ques


BEGINNING POSITION

Del

ta N

eutra

l Hed

ge


BEGINNING POSITION

Position Quantity Price Value Profit / Loss

Convertible Long Position

1000 1000 $1,000,000

Short Stock Position

16000 40 -$640,000

Stock Price Moves 1%


1000 1006.4 $1,006,400 $6,400


16000 40.4 -$646,400 -$6,400

Net Profit / Loss $ - Delta = 0.64Del

ta N

eutra

l Hed

ge


CHANGE IN DELTA AS STOCK PRICE CHANGES

Del

ta N

eutra

l Hed

ge


CHANGE IN DELTA AS STOCK PRICE CHANGES



1000 1006.4 $1,006,400


16000 40.4 -$646,400

Stock Price Moves another 1%


1000 1012.89 $1,012,890 $6,490


16000 40.8 -$652,800 -$6,400

Net Profit / Loss $90Delta = 0.651Del

ta N

eutra

l Hed

ge


RE-BALANCING REQUIRED

Del

ta N

eutra

l Hed

ge


RE-BALANCING REQUIRED



1000 1006.4 $1,006,400


16225 40.4 -$655,490

Stock Price Moves 1%


1000 1012.89 $1,012,890 $6,490


16225 40.8 -$661,980 -$6,490

Net Profit / Loss $ -Delta = 0.651Del

ta N

eutra

l Hed

ge


GAMMA-CAPTURE HEDGE

Arb

itrag

e Te

chni

ques


GAMMA-CAPTURE HEDGE


Short Underlying Stock at current DeltaSame as Delta Hedge

Arb

itrag

e Te

chni

ques


GAMMA-CAPTURE HEDGE


Short Underlying Stock at current DeltaSame as Delta Hedge

However

Hedging ratio is different in order to capture Gamma

CV= Gamma ( )

S2

2

Sacrifice some cash flow for greater capital gain

Arb

itrag

e Te

chni

ques


BULLISH-GAMMACAPTURE HEDGE

Quantity Price Value Convertible Long Position 100 950 $95,000

Short Stock Position -700 53 -$37,100

Downside Target Price Current Price Upside Current PriceStock Price $35.50 $53.00 $79.05

Convertible Price $830.00 $950.00 $1,192.50Delta 0.3 0.54 0.75

P/L Convertible -$12,000.00 $ - $24,250.00P/L Stock $12,250.00 $ - -$18,235.00Coupons $4,250.00 $4,250.00 $4,250.00

Stock Dividends $ - $ - $ -Short Credit Interest $1,394.00 $1,669.50 $2,080.00

Total P/L $5,894.00 $5,919.50 $12,345.0012 month ROI 6.20% 6.23% 12.99%

Gam

ma

Cap

ture

Hed

ge


Risk Exposures


NOT FOOL-PROOF!

Risk

Exp

osur

es

Source: Dow Jones Hedge Fund Strategy Benchmarks : Convertible Arbitrage Fact Sheet


NOT FOOL-PROOF!

Risk

Exp

osur

es

Source: Dow Jones Hedge Fund Strategy Benchmarks : Convertible Arbitrage Fact Sheet

-30

-22.5

-15

-7.5

0

7.5

1/02 7/02 1/03 7/03 1/04 7/04 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08

Monthly Returns After Fees(%)


NOT FOOL-PROOF!

Risk

Exp

osur

es


NOT FOOL-PROOF!

Risk

Exp

osur

es

Default Risk1


NOT FOOL-PROOF!

Risk

Exp

osur

es

Default Risk1

Unwinding their positions prior to realizing bond’s fundamental

values

2


TYPES OF RISKS INVOLVED

Risk

Exp

osur

es

Risks



Risk

Exp

osur

es

Risks

Credit



Risk

Exp

osur

es

Risks

Credit

Equity Market



Risk

Exp

osur

es

Risks

Credit Leverage

Equity Market



Risk

Exp

osur

es

Risks

Credit Leverage

Equity Market

Interest Rate



Risk

Exp

osur

es

Risks

Credit Leverage

Equity Market

Interest Rate

Liquidity



Risk

Exp

osur

es

Risks

Credit Leverage

Equity Market

Interest Rate

Currency

Liquidity



Risk

Exp

osur

es

Risks

Credit Leverage

Execution

Equity Market

Interest Rate

Currency

Liquidity


The ‘Da Vinci’ Code


POSITIVE CARRY MODEL

The

‘Da

Vin

ci’ C

ode



The

‘Da

Vin

ci’ C

ode

Carryt

current income of delta neutral position

financing cost of delta neutral position



The

‘Da

Vin

ci’ C

ode

current income of delta neutral position financing cost of delta neutral position

(Bt*Cyt)+(deltat*Bt*OBRt- s – dyt) – (Capt * OBRt + (Bt-Capt) * Lt)



The

‘Da

Vin

ci’ C

ode

(Bt*Cyt)+(deltat*Bt*OBRt - s – dyt) – (Capt * OBRt + (Bt-Capt) * Lt)



The

‘Da

Vin

ci’ C

ode

(Bt*Cyt)+(deltat*Bt*OBRt - s – dyt) – (Capt * OBRt + (Bt-Capt) * Lt)

Current yield of bond at time t

Short financing charge

Capital base required to

establish position

Price of convertible bond at time t

Overnight bank rate

Dividend compensation paid to stock lender as percentage of Bt

Leverage rate



The

‘Da

Vin

ci’ C

ode



The

‘Da

Vin

ci’ C

ode

Cyt + deltat*OBRt - s – dyt) – ((OBRt – Lt)*(Capt/Bt) + Lt) > 0

::Condition for starting the carry strategy::



The

‘Da

Vin

ci’ C

ode

Cyt + deltat*OBRt - s – dyt) – ((OBRt – Lt)*(Capt/Bt) + Lt) > 0

::Condition for starting the carry strategy::

Position is held until this condition is rendered

void!


CALCULATING RETURNS

The

‘Da

Vin

ci’ C

ode


CALCULATING RETURNS

The

‘Da

Vin

ci’ C

ode

Vt = Bt - SStMarked-to-market

portfolio value for day t deltat*Bt


CALCULATING RETURNS

The

‘Da

Vin

ci’ C

ode

Vt = Bt - SStMarked-to-market

portfolio value for day t deltat*Bt

Rt = ((Vt - Vt - 1) + (SSt-1*OBRt – s – dyt)-(Bt-1-Capt-1)*Lt-1)

Capt-1

::Therefore::

Daily return on the positive carry trade


OPTIMIZING

The

‘Da

Vin

ci’ C

ode


OPTIMIZING

The

‘Da

Vin

ci’ C

ode

CFDs as proxies for shorting

(deltat*Bt*OBRt – s – dyt)

((0.9*deltat*Bt*OBRt)-dyt)


OPTIMIZING

The

‘Da

Vin

ci’ C

ode

Minimizing Lt

(Capt*OBRt + (Bt – Capt)*Lt)

Bt*OBRt


OPTIMIZING

The

‘Da

Vin

ci’ C

ode

Maximizing OBRt

((0.9*deltat*Bt*OBRt)-dyt)

(20(0.9*deltat*Bt*OBRt) – dyt)


REAL LIFEAPPLICATION

The

‘Da

Vin

ci’ C

ode



The

‘Da

Vin

ci’ C

ode

Issue Date 16 October 2009

Conversion Price $3.0853/share

Min. Denomination US$100,000

Issue Price 1.0 Par

Board Lot Size US$200,000

Fixed Exchange Rate S$1.440=US$1.00

Conversion Ratio 93,345.8659

Overnight Bank Rate 0.2796%

Singapore Prime rate 5%

Delta 0.6

Capital Base 15% of long position

Olam 6% CB 15102016



(RESULTS)

The

‘Da

Vin

ci’ C

ode

Carryt

OCt

Return

Fund Management Fees (20/2)

-$23,241.8

$87,400

58.26%

$148,172



(RESULTS)

The

‘Da

Vin

ci’ C

ode

Carryt

OCt

Return

Fund Management Fees (20/2)

-$23,241.8

$87,400

58.26%

$148,172

BOOMZ!


Q & A


Q & A

A presentation by TY ‘Da Vinci’ Thong Fund...


Economy & Finance

Fi (convertible arbitrage)