Business, Legal & Accounting Glossary
An arbitrage strategy which involves buying a convertible security while simultaneously selling short the same company’s common stock. This strategy involves identifying stocks that are mispriced by the market, shorting the stock and buying a convertible security issued by that company. Having sold the stock short, the investor puts proceeds in an interest-bearing account. If the stock price stays the same, then the investor will earn interest on the short sale proceeds and interest on the convertible security, while paying fees to the lender of the stock.
In most cases, this situation will lead to a positive net cash flow. If the stock price rises, then the investor gains on the convertible stock, but loses (hopefully a smaller amount) on the short sale position. If the stock price falls, the price of the convertible falls, but the value of the convertible will never fall below the value that an ordinary bond issued by the company would have. On the other hand, the investor makes a gain on the short position (hopefully more than the amount lost on the convertible). A convertible hedge is considered a relatively safe strategy, but choosing which ones to pursue is complex and so convertible hedges are done primarily by professional investment managers who are supported by powerful analytical tools.
When you use a convertible hedge, you purchase a convertible bond that can be exchanged for shares of the company’s common stock under certain conditions. Simultaneously, you sell short the same company’s common stock. The goal, as with any hedge, is to make more money on one transaction than you lose on the other. For example, if the stock price falls, you can profit from the short sale while also knowing that the convertible bond will remain at least as valuable as other bonds issued by the company. If, on the other hand, the stock rises in value, you hope to make more money by selling the convertible or exchanging it for shares you can sell than it costs you to borrow and repay the shares you sold short. There are no guarantees that this or any other hedging strategy will work, particularly for an individual investor who must identify an appropriate security to hedge and the appropriate time to act.
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This glossary post was last updated: 5th April, 2022 | 0 Views.