What Is a Chinese Hedge?

A Chinese hedge is a tactical position that seeks to capitalize on mispriced conversion factors while protecting investors from risk. It involves establishing a short position in a convertible security and a long position in the convertible's underlying asset. The trader stands to profit when the underlying asset depreciates, diminishing the premium on the convertible security.

Key Takeaways

  • A Chinese hedge is a strategy that involves the simultaneous selling of a convertible security, usually a convertible bond, along with buying the underlying issuer's shares.
  • This type of trade, also known as a reverse hedge, is essentially the opposite position of a set-up hedge.
  • A Chinese hedge is a lower-risk strategy since price changes in one position offset the other; however, shorting a convertible bond may come with its own unique set of risks.

Understanding the Chinese Hedge

A Chinese hedge, also known as a reverse hedge, is a type of convertible arbitrage. A convertible security, such as a bond with an option to convert into shares, sells at a premium to reflect the cost of the option. The trader wants the underlying asset to drop in value, making the short position on the convertible profitable. By hedging the short position by longing the underlying asset, the investor is protected by large appreciations.

This would be the opposite of executing a set-up hedge, which is a convertible arbitrage strategy that involves a long position in a convertible security and shorting its underlying stock. This type of hedge also looks to capitalize on mispriced conversion factors, while isolating risk unrelated to the error. 

The trader profits when the underlying asset rises in value, increasing the premium on the convertible security. 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. By hedging the long position by shorting the underlying asset, the investor is protected by depreciation​​​ in the bond's price.

Risks Involved with a Chinese Hedge

A convertible bond offer may contain stipulations limiting the investor's ability to successfully achieve a Chinese hedge:

  1. The convertible bond may feature a call provision. Such an option allows the issuer to purchase the security back from bondholders. The issuer can compensate bondholders with cash, or they can deliver shares to them via a forced conversion. If the investor receives cash from the issuer, it may not be sufficient to cover the short position. One who is short a convertible must also surrender their position.
  2. The convertible bond may stipulate a waiting period before the investor can initiate the transaction or limit conversion to a particular annual period.

Either scenario demonstrates that a convertible bond may not necessarily cover the risk inherent in a short stock position in its entirety.

Chinese Hedge as Insurance

A Chinese hedge strategy is a form of insurance. Hedging in a business context or in a portfolio is about decreasing or transferring risk. Consider that a corporation may choose to build and operate a factor in a foreign country that it exports its product to so that it can hedge against currency risk

When investors hedge, their goal is to protect their assets. Hedging may imply a conservative approach to investing, but some of the most aggressive investors in the market use the strategy. By reducing the risk in one part of a portfolio, an investor can often take on more risk elsewhere, increasing their potential for absolute returns while putting less capital at risk in each individual investment.

Another way to look at it is that hedging against investment risk means strategically using instruments in the market to counteract the risk of adverse price movements. In other words, investors hedge one investment by making another.