A Chinese Hedge is a form of arbitrage by which an investor shorts a convertible bond and buys the underlying common stock. The inverse of a Set-Up Hedge, a Chinese Hedge is a bet that a stock's price will rise, taking the value of the convertible bond up with it but reducing the conversion premium associated with the convertible (the price of a convertible bond is tied closely with the underlying stock's price).

When a stock's price is low, the convertible's price is also low, but the premium over and above the actual conversion ratio is high because of the potential for price appreciation. As the stock's price rises, so does the convertible (making the conversion premium less attractive, because the potential for price appreciation is lessened). Depending on the convertible bond's interest rate, a Chinese Hedge may be a very low cost/low risk way of participating in a stock's price appreciation. (For more on this, read A Beginner's Guide to Hedging)

  1. What is a 'busted' convertible bond?

    Learn about busted convertible bonds; these are hybrid securities with conversion prices significantly higher than the market ... Read Answer >>
  2. What is the difference between convertible and reverse convertible bonds?

    The difference between a regular convertible bond and a reverse convertible bond is the options attached to the bond. While ... Read Answer >>
  3. Where does the stock come from when convertible bonds are converted to stock?

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  4. How do I use a premium put convertible?

    Holders of convertible bonds face all the pitfalls that traditional bondholders face - liquidity risk, interest rate risk ... Read Answer >>
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  1. Chinese Hedge

    A position that protects investors from risk, involving a short ...
  2. Convertibles

    Securities, usually bonds or preferred shares, that can be converted ...
  3. Set-Up Hedge

    An arbitrage strategy involving a long position in a convertible ...
  4. Convertible Arbitrage

    A trading strategy that typically involves taking a long strategy ...
  5. Market Conversion Price

    An investor's effective cost to purchase common stock when it ...
  6. Convertible Security

    An investment that can be changed into another form. The most ...
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