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 is about establishing a short position in a convertible security and a a long position in the convertible’s underlying asset. The trader is likely to profit when the underlying asset depreciates, which lowers the premium on the convertible security.
Key points to remember
- A Chinese hedge is a strategy that involves the simultaneous sale of a convertible security, usually a convertible bond, and the purchase of the shares of the underlying issuer.
- 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, selling a convertible bond short may carry its own 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 convertible into shares, sells at a prime to reflect the cost of option. The trader wants the underlying asset to fall in value, making the convertible short profitable. By covering the short position by sucking in the underlying asset, the investor is protected by strong appreciations.
This would be the opposite of running a set-up hedge, which is a convertible arbitrage strategy which involves a long position in a convertible security and a short sale of its underlying stock. This type of hedging also seeks to capitalize on mispriced conversion factors, while isolating non-error risk.
The trader profits when the value of the underlying asset increases, which increases the premium on the convertible security. A convertible security, such as a bond convertible into common stock, sells at a premium to reflect the cost of the option. By covering the a long position by taking a short position in the underlying asset, the investor is protected against depreciationin the price of the bond.
Risks associated with a Chinese hedge
A convertible bond offer may contain stipulations limiting the investor’s ability to successfully hedge China:
- The convertible bond may include a call provision. Such an option allows the issuer to redeem the security from the bondholders. The issuer may remunerate bondholders in cash or deliver shares to them via a forced conversion. If the investor receives cash from the issuer, it may not be enough to cover the short position. An investor who is short on a convertible must also exit their position.
- The convertible bond may stipulate a waiting period before the investor can initiate the transaction or limit the conversion to a particular annual period.
Either scenario demonstrates that a convertible bond does not necessarily hedge the risk inherent in a short equity position in its entirety.
Chinese hedge as insurance
A Chinese hedging strategy is a form of insurance. Cover in a business context or a portfolio, it is about reducing or transferring risk. Consider that a company may choose to build and operate a factory in a foreign country to which it exports its product, in order to reduce its costs and protect itself against risk of change through local operations.
When investors hedge, their goal is to protect their assets. Coverage may involve a conservative approach to invest, but some of the most aggressive investors in the market use this strategy. By reducing risk in one part of a portfolio, an investor can often take on more risk elsewhere, thereby increasing their potential for absolute returns while putting less capital at risk in each individual investment.
Another way of looking at it is that hedging against investment risk means to use strategically instruments in the market to counter the risk of adverse price movements. In other words, investors hedge one investment by making another.
