ten, convertible bonds or preferred shares are issued by young companies
whose common stock is capable of significant gains or losses.
The option may be difficult to value because the issue may contain
other provisions. The option grants the right to convert for a specific pe-
riod beginning in the future and continuing to a specified expiration date.
The terms of the conversion may change over time. The issuing company
may also own a call option or other provisions to force the owner of the
convertible security to convert.
To complicate the valuation, realize that the conversion option gives
the owner the right to exchange one asset (the bond or preferred shares)
for common stock. Frequently, the value of the bond or preferred stock
moves up and down along with the value of the common stock. If the com-
pany is successful, its stock rises because of the prospect of higher earnings.
The value of its debt also rises because bondholders face lower risk of de-
fault. If a company does poorly, its stock declines. The value of its debt
may also decline because of the heightened risk of default.
The convertible arbitrage fund usually buys the convertible issue and
sells short the underlying common stock as a hedge. As constructed, this
combination will generally be profitable if the common stock moves up or
down significantly but will usually lose money if prices remain steady.
Hedge funds may design an option hedging strategy to increase the
consistency of performance. The fund may sell listed or over-the-counter
stock options to approximate selling the option rights in the convertible se-
curity. Properly constructed, the strategy may enable the hedge fund to ex-
pect to make money regardless of whether the common shares rise or
decline and whether the movement is great or small.
Fixed Income Arbitrage
Fixed income arbitrage incorporates a number of strategies. The largest
risk factor for most bonds is the general level of interest rates. Most inter-
est rates tend to move up and down together, so a short position can
closely hedge a long position for most fixed income securities.
Like the equity index arbitrage strategy, a hedge fund may buy bonds
and sell futures. This trade is called the bond basis and has optionlike char-
acteristics. The combination is a low- risk strategy and is profitable when
interest rates move up or down significantly from the beginning level. The
trader profits from the optionality of the relationship when large move-
ments occur.
Fixed income arbitrage funds may also hedge long positions in cash se-
curities by selling combinations of Eurodollar futures. Generally, traders
seek out bonds with somewhat higher yields because they are not free from
Hedge Fund Investment Techniques
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