Part 7-Investors of convertibles: Hedging and arbitrage.Investorsperspectiveson convertibles.Convexity ratio:equity-likereturnwithless risk·Bustedconvertibles.Hedgingwith stockand options
Part 7 – Investors of convertibles: Hedging and arbitrage • Investors’ perspectives on convertibles • Convexity ratio: equity-like return with less risk • Busted convertibles • Hedging with stock and options
Investors who are restricted in theirequityholdingsExample Florida Department of Labor prohibits selfinsurance funds from investing in any equities·Convertibles,despite their equity component,aretypically classified as fixed-income instrumentsThese restricted investors will profit from theequity like payoffs available with convertibles andincrease their diversification
Investors who are restricted in their equity holdings Example Florida Department of Labor prohibits selfinsurance funds from investing in any equities. Convertibles, despite their equity component, are typically classified as fixed-income instruments. These restricted investors will profit from the equity like payoffs available with convertibles and increase their diversification
ArbitragespecialistsThey attempt to lock in profits due tomisalignment between the equity market and theconvertibles.They are less concerned with thepositive outlook of the equity
Arbitrage specialists They attempt to lock in profits due to misalignment between the equity market and the convertibles. They are less concerned with the positive outlook of the equity
Equity-like returns with less riskConvertible securities are an appropriate investmentvehicle for long-term investors seeking a high rate oftotal return but with less risk than common stockConvertible investors hope toearn two-thirds of theupside return with only one-third of the downsiderisk.-In bull markets, convertibles have trailed globalequity markets by only a few percentage pointIn bear markets convertibles offer considerablymore downside support
Equity-like returns with less risk Convertible securities are an appropriate investment vehicle for long-term investors seeking a high rate of total return but with less risk than common stock. Convertible investors hope to earn two-thirds of the upside return with only one-third of the downside risk. - In bull markets, convertibles have trailed global equity markets by only a few percentage point - In bear markets convertibles offer considerably more downside support
ConvexityratioClassic two-thirds upside,one-third downside”Convexity ratio is the ratio of upside and downsideparticipationFor example,suppose theconvertible provides 64%of theupside participation with only34%of the downsidemovement, then the convexity ratio is 1.85.That is, theconvertible provides 85%more upside participation thandownside risk
Convexity ratio • Classic “two-thirds upside, one-third downside” • Convexity ratio is the ratio of upside and downside participation. For example, suppose the convertible provides 64% of the upside participation with only 34% of the downside movement, then the convexity ratio is 1.85. That is, the convertible provides 85% more upside participation than downside risk