What is Set-Up Hedge?

A set-up hedge is an investing strategy utilized by hedge funds, which involves the simultaneous buying of a convertible security, usually a bond, and the selling of the underlying stock's shares.

Key Takeaways

  • A set-up hedge is an investing strategy utilized by hedge funds, which involves the simultaneous buying of a convertible security, usually a bond, and the selling of the underlying stock's shares.
  • A convertible bond is often a bet that a stock's market price will appreciate in value while shorting a stock is a bet that the market price will decrease.
  • As implied in the term, set-up hedge, this strategy is designed to lead to financial gain whether the underlying security goes up or down in price while mitigating risk.

Understanding Set-Up Hedge

A set-up hedge is a form of convertible bond arbitrage which should benefit the investor whether or not the underlying stock increases or decreases in value. The hedge consists of two elements: first, a bond that can be converted into stock of a publicly traded company and, second, a short position in the underlying stock. As implied in the term, this strategy is designed to lead to financial gain whether the underlying security goes up or down in price while mitigating risk.

Convertible bonds tend to offer a slightly lower coupon rate than a comparable non-convertible bond. The option to convert the bond into shares allows the company to pay less interest to the bondholder. The bond will also specify a share price at which the bond can be converted into stock. This conversion price will include a premium, often 15% to 25%, above the current share price. If the market price climbs above the conversion price, the investor will convert their bond into shares and sell those shares at the higher market price. Thus, a convertible bond is often a bet that a stock will appreciate in value.

The other side of a set-up hedge is a short position in the underlying stock. An investor takes such a position by borrowing shares from the inventory of a broker-dealer and selling them on the open market. If the share price goes down, the investor can buy those shares back at a lower price and replace them in the broker's inventory. They will pocket the difference between the short sale and the buyback. Thus, a short sale is a bet that the market price of a stock will decrease.

Set-Up Hedge Risks

The set-up hedge may sound like a guaranteed gain, but there are significant risks that can limit returns or lead to major losses. Any investor considering a short sale will require special approval by the investor's broker. The broker needs to confirm that the client understands the risk involved. A short-sell can involve unlimited risk if the share price goes through the roof.

A convertible bond offer may contain stipulations limiting the investor's options if such an increase in stock price takes place, such as:

  1. The convertible bond may feature a call privilege or option. 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.
  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.