Convertible Hedge

DEFINITION of 'Convertible Hedge'

A trading strategy that consists of a long position in a company's convertible bond or debenture, and a simultaneous short position in the underlying common shares. The convertible hedge strategy is designed to be market neutral, while generating a higher yield than would be obtained by merely holding the convertible bond or debenture alone. A key requirement of this strategy is that the number of shares sold short should equal the number of shares that would be acquired by converting the bond or debenture.

BREAKING DOWN 'Convertible Hedge'

The rationale for the convertible hedge strategy is as follows: if the stock trades flat or if little has changed, the investor receives interest from the convertible security plus interest from the short sale proceeds (less any costs to borrow the shorted shares and margin requirements). If the stock trades lower, the short stock position will be profitable, offsetting any decline in the price of the convertible bond or debenture. Conversely, if the stock appreciates, the loss on the short position would be offset by the gain in the convertible security.

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RELATED FAQS
  1. How is a debenture stock different from a regular debenture?

    Learn to differentiate between standard debentures and debenture stocks, which are equities that act more like preferred ... Read Answer >>
  2. 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. ... Read Answer >>
  3. Where does the stock come from when convertible bonds are converted to stock?

    First, let's define convertible bonds. A unique combination of debt and equity, they provide investors with the chance to ... Read Answer >>
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