onvertible Arbitrage strategies traditionally invest in the convertible elements of a company's capital structure (i.e., convertible bonds, warrants and convertible preferred stock). Managers in this category buy or sell these securities and then hedge some or all of the associated risks. These risks include changes in the price of the underlying stock, changes in expected volatility of the stock, changes in the level of interest rates and changes in the credit standing of the issuer. In addition to collecting the coupon on the underlying convertible bond, Convertible Arbitrage strategies will typically make money if the expected volatility of the underlying asset increases or if the price of the underlying asset changes rapidly. Depending on the hedge strategy, the strategy will also make money if the credit quality of the issuer improves (short the credit differential). Because of the insights these managers gain from their necessarily deep analysis of the capital structure, they may from time to time make opportunistic investments in non-convertible securities or in special situations.

The evidence on why convertible bonds should be systematically underpriced focuses on market segmentation. The market segmentation hypothesis suggests that the markets for different types of securities, such as stocks and bonds, are not closely integrated. Securities that do not change type through time will be preferred to securities that change their types. Convertible bonds frequently do change type. If the issuer does well, the bond behaves like a stock. If the issuer does poorly, the bond becomes distressed debt. If little happens, it behaves like a bond. It should not be surprising that investors discount these securities, as they understand there is a high probability that a given convertible will change type at least once during the life of the security.