Question
A convertible bond (CB) arbitrage hedge fund manager buys ten convertible bonds with a PAR Value of $1,000 paying an annual coupon of 3.5%. The
A convertible bond (CB) arbitrage hedge fund manager buys ten convertible bonds with a PAR Value of $1,000 paying an annual coupon of 3.5%. The CB purchase price was $980 per bond. Each CB is convertible into 40 shares of common stock at $20 per share which is also the current share price. The hedge fund manager has determined that the appropriate hedge ratio is 0.70. The manager has the ability to earn a short rebate of 2.0% on the underlying stock and pays 4.0% on any borrowed funds for the CB purchase.
If the manager has entered into the position with a 2-to-1 leverage ratio (i.e., borrow 50% of the capital) and after one year, the price of the bonds jumps to $1020 with the stock price at $21, calculate the managers return on investment (in both dollar amount and percentage). (20 Marks
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