If converts are systematically “cheap”, why does the gap not close instantly? Funding withdrawals, bond illiquidity, and crowded hedge-fund exits let discounts persist—and can widen them after the desk is already long. A long convertible is not an unencumbered claim on eventual convergence: it is collateral financed through a prime broker, paired with a short that must remain borrowable, and marked daily in a market that may have no real bid.
This note makes the funding spiral explicit as the practical convert-market reading of limits to arbitrage. The agency model belongs in The Limits of Arbitrage; the job here is to identify the operational state variables—haircuts, margin, rehypothecation, financing tenor, exits, and flows—that force the desk to act before the model’s convergence date.
Learning objectives. By the end of this note you should be able to:
- distinguish asset liquidity from funding liquidity;
- map the funding spiral (marks → haircuts → sales → marks);
- explain why rational desks may not correct mispricing immediately;
- connect the desk spiral to Shleifer–Vishny performance-based arbitrage.
- distinguish loss of economic value from loss of funding capacity.
In this lesson
- Two liquidities
- The spiral
- Why mispricing persists (applied)
- Early warnings and policy
- Funding is an option on time
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
Read the full lessonNew to SelfMadeQuant.com? See membership options or browse the Convertible Arbitrage syllabus.