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A convertible bond is simply a bond, with the inherent credit risk issues, and a
call option. You hedge the call option by shorting "delta" shares of the common
stock. Delta is the hedge ratio or relative sensitivity of the call imbedded in
the convertible. Almost all of the short interest in securities where options or
converts trade relates to arbitrage transaction.
The hedge works unless two things happen
1. The underlying bond defaults or deteriorates so bad that the decline in the
value derived from the expected cash flow exceeds any fixed income hedging you may
have done. Your friend implied no fixed income hedging and I'm not certain what
happened with the Boston Chicken Bonds...it would also depend on how "cheap" they
were when he bought them as the company filed bankruptcy.
2. The stock changes in price so rapidly that "delta" hedging doesn't effectively
hedge the position. This is common when large gaps in the price of the common
occur. Being able to buy the convert and hedge out the stock risk, though, is
kind of nonsense for an individual investor. They simply cannot hedge out the
bond quality risk....if I have to live with the bond quality risk then why not
have the stock upside. What your friend may have done is overhedged....shorted
more stock than the convertible related too. Then their profit actually came from
their assumption of short risk....not the convertible bond arb. play.
You might also want to be aware that the trading in these types of structured
option instrument is a huge business and in many issues far exceed the trading in
the visible listed options market. The street just brought a convert on Amazon .
The deal was, I believe, a 4 3/4 coupon with a call struck somewhere around 25%
OTM. The call allows the company to raise funds at 4 3/4%... a rate substantially
below market for a firm with their credit risk. Do they give up equity in
exchange? How else would they have raised the money? The original issues was
slotted at about 1/2 Billion and the final deal was twice that.
ChrisPR1@xxxxxxx wrote:
> A friend commented to be about a trade he did earlier last year::::
> He was long the Boston Chicken Convertible Bond (don't remember the conversion
> factor) and short an equivalent amount of stock that the bond allowed him to
> convert into. He collected the bond yield while the stock dropped...because
> he was confident that the stock was overvaled at the time based on ta and fa,
> he managed to make a healthy return for himself. His reasoning continued that
> if he was wrong and the stock moved against him, the bond allowed him to
> convert to cover the short.....
> Obviously, this trade worked out well, but my interest lies in what the
> relative amount of risk is carrying this position.....
> Comments please.....
> Chris
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