DEFINITION of 'Set-Up Hedge'

An arbitrage strategy involving a long position in a convertible security and shorting its underlying stock. A set-up hedge looks to capitalize on mispriced conversion factors, while isolating risk unrelated to the error. The trader will profit when the underlying asset appreciates, increasing the premium on the convertible security.

BREAKING DOWN 'Set-Up Hedge'

A set-up is a type of convertible arbitrage. A convertible security, such as a bond with an option to convert to shares, sells at a premium to reflect the cost of the option. The trader hopes that the underlying asset will rise in value, correcting the mispriced conversion factor, making the long position in the convertible profitable. By hedging his long position through shorting the underlying, the investor is protected by depreciations in the bond.

This is the opposite of executing a "Chinese Hedge".

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RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. 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 >>
  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 >>
  5. 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 >>
  6. Why would a corporation issue convertible bonds?

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