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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