What is a Chinese Hedge
A Chinese hedge is a tactical position that looks to mitigate risk for investors. It involves a short position in a convertible security and a long position in its underlying asset. This type of hedge looks to capitalize on mispriced conversion factors. The trader will profit when the underlying asset depreciates, diminishing the premium on the convertible security.
BREAKING DOWN 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 an 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.
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.