Convertible note hedging
This is a little out of my league and don't have anyone that plays in convertible note market in my network so I thought I'd ask here.
Is there a standard hedge ratio that long holders of convertible notes use? If the notes are expected to convert 100 million shares, do the holders hedge by going short a specific amount of the 100 million. Eg 50% hedge ratio (50 million shares) etc? Or is it a case by case basis?
I ask because I'm long a position that has recently issued convertible notes. It's been hammered in a sell off since and I've calculated about 40-50% of the shares that can be converted have been hedged. I'm just trying to understand the dynamics here and wonder if that number will increase.
I hope that all makes sense.
Thanks.
In the realm of convertible notes and their hedging strategies, there isn't a one-size-fits-all answer, but I can provide some insights based on the WSO content that touches on similar topics. The hedge ratio for holders of convertible notes often depends on several factors, including the investor's outlook on the underlying stock, the convertible note's terms (such as the conversion rate and the conversion price), and the market conditions.
Case-by-Case Basis: Typically, the decision on how much of the position to hedge is indeed a case-by-case basis. Investors might consider the volatility of the underlying stock, the delta of the convertible note (which measures the sensitivity of the note's price to changes in the price of the underlying stock), and their own risk tolerance.
Delta Hedging: A common strategy used in hedging convertible notes is delta hedging, where the hedge ratio might adjust as the delta changes. This involves shorting a percentage of the shares that the notes can convert into, based on the delta. For example, if the delta is 0.5 (or 50%), an investor might hedge by shorting 50% of the shares they could receive upon conversion. This ratio can change as the delta changes, requiring continuous adjustment to the hedge.
Market Conditions and Investor Sentiment: The extent to which holders decide to hedge can also be influenced by market conditions and their view on the future direction of the stock. If the stock has been hammered in a sell-off, as you mentioned, investors might increase their hedge ratio to protect against further downside, which could explain the 40-50% hedging you've observed.
Strategic Considerations: Some investors might choose a specific hedge ratio based on strategic considerations, such as protecting capital or leveraging potential upside. For instance, if they believe the stock's sell-off is overdone and expect a rebound, they might opt for a lower hedge ratio to benefit from the upside.
In your case, observing that 40-50% of the shares that can be converted have been hedged, it suggests that investors are taking a cautious approach, possibly due to the recent sell-off. Whether this number will increase depends on how investors' expectations evolve regarding the stock's future performance and how the market conditions change.
Remember, hedging strategies can be complex and carry their own risks, so it's always a good idea to consult with a financial advisor or someone experienced in convertible securities before making any decisions.
Sources: Safe leverage / coverage ratio for LBOs during holding period?, Appropriate hedge in turnaround situation, Q&A Discretionary Hedge Fund Trader, Difficulty Check, Hedging Choices (Experienced Traders)
Think back to options pricing.
They short a variable amount of shares equal to the delta of the bond.
Try CNVG in Bloomberg or if you want to lose. something, Quantlib
Your hedge ratio is too large or you're not holding the position for long enough. Remember that short interest is very expensive over time and these convertible bonds if they don't make the strike price can be basically a straight bond without any option value. What you want doing convertible arbitrage is large and fast swings in the equity price so you can capture the volitility movment. Like WSO bot mentioned, to do this you generally need to rebalance your heding ratios based on the delta or volitilty of the security. You make money by predicting a more accurate delta hedge based on a companys credit profile and volitility. The one thing is that in terms of credit weakness, your shorts are not going to cover the losses of your bonds so you should be really long oreiented in the position.
Remember, if the conversion price is reached you're going to be making equity like profits minus short interest, but if the bond defaults you lose all value plus you don't recover the same on the short position.
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