KBC Alternative Investment Management (A): Convertible Bond Arbitrage

Case A: To extract cheap volatility in Duke Energy convertible bonds, Mark Punt, a convertible arbitrageur at KBC AIM, purchases the bonds and delta hedges them with a short position in the company's shares. To manage the credit risk of his long convertible bond position, Mark faces a choice of hedging with CDS, shares of the company or out-of-the-money puts on the company's stock. Key to his hedging strategy is an understanding of the observed negative correlation between credit spreads and share prices for Duke Energy.