Chinese Hedge

  

Before they got the idea of building a wall out of stones and bricks, China's Ming dynasty tried to keep barbarians out using really tall plant formations. This "Chinese Hedge" was a colossal failure (attempts to brand it the "Great Hedge of China" were roundly mocked).

Eh, okay...this is actually the name of a trading hedge. The more culturally sensitive name for this position is a "reverse hedge." It's a way to arbitrage market fluctuations in the prices of convertible securities.

Take a convertible bond. This type of security acts like a standard corporate bond (with an interest rate and maturity date, etc.) and has the added benefit of an option to convert it into shares of stock under certain conditions. Because of this additional benefit, these bonds trade at a premium compared to vanilla bonds from the same company with similar rates and maturities.

In a Chinese hedge, you are attempting to profit on a potential overvaluation of this convertibility. Basically, you think the market has priced in too much of a premium for the convertible part of the bond. So you short the convertible security (bet that its price will go down), while going long the underlying stock (basically, buying shares). Then, if the stock goes up, messing up your short on the convertible instrument, the investor can profit on the rise in the stock price.

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Finance: What is a hedge fund?41 Views

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finance a la shmoop. how does a hedge fund work? so you've probably heard a lot

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about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]

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your money. that hedge funds are only investing vehicles for the wealthy and

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how mathy their employees are. but the actual workings of a hedge fund are a

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lot like driving down a road in wartime. there are hills and there are valleys

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your car will Traverse wanting it to speed up and slow down but as long as

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you continue to drive 37 miles an hour the enemy radar can't detect you so you

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drive theoretically, safely down the road. alright so how does this translate to

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financial investments in a hedge fund well essentially every investment made

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on an entity going up in value is usually offset by making a bet on a

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different entity going down in value. that's called hedging got it? the economy

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is coming out of the doldrums and you believe the entire stock market is gonna

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recover but you believe the worst companies which have been down some 90% [chart showing decline]

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in this bad bear market environment will actually do better over the next period

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of time than high quality companies like Coca Cola which didn't decline as much.

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that is yes Coca Cola stock will improve and you think it has Headroom to run

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upwards some 30% in the next year and a half but you believe crap burgers

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dot-com which went from $100 a share at its peak to only $2 today could

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quadruple to 8 bucks in value over that same 18 months. like you get a much

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better percentage return on crap burgers than you do on coke. so as a hedge fund

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manager one quote easy unquote trade that you'll make is too short coca-cola

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betting essentially that it will go down, and then putting the same amount of

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money to being long crap burger com betting essentially that it'll go up. in

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essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]

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than coca-cola will go up but if the overall market goes down

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well you'll be hedged in that you're short Coca Cola position will cushion

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the blow of crap burgers further demise and it's likely you're looking at crap

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burgers balance sheet and thinking well they have $2 a share in cash and no debt

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how much lower can they go .got it? hedge funds use stock options

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aggressively to manage risk in their portfolios the promise hedge funds make

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to investors is that their performance will be up and/or good whether the

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market goes up down or stay sideways. so another common hedge trade involves the

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use of put options on the market to protect the long trades the fund is

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making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]

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and believes that they will be up significantly over the next two to three

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quarters earnings reports. but it's also nervous about nukes in North Korea in

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order to protect against a bomb going off and the whole market going down and

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ruining its investment performance, and yes there are bigger things to worry

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about then but that doesn't matter to hedge funds not their job. the hedge fund

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goes long the three stocks it likes but it buys put options on the market

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betting with those options that the market itself will go down. it's

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essentially playing both sides of the fiddle so that hopefully it wins in any

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set of circumstances. and yeah it's a lot more complicated than that in practice

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we're just given the idea here. in the case of a put option the market might be

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trading at ten thousand and a put option might have a strike price of nine

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thousand such that if the market declines below nine thousand the put [strike price illustrated]

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option goes quote in the money unquote and pays the investor handsomely for

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making the bet that the market would go from ten thousand and well somewhere

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below nine thousand. if that happened the three long stock bets that the hedge

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fund made would go down but their decline would be hopefully more than

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offset by the gains from the put options the hedge fund bought that were

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portfolio life insurance in the case the market puked. and if that happens well

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all you can really do is offer the market a breath mint and a moist

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towelette and then be sure to collect your fee. [person representing stock market offered towelette]

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Finance: What is a Derivative?
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Find other enlightening terms in Shmoop Finance Genius Bar(f)