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What is a Chinese hedge?

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)

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