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Technology Stocks : Lucent Technologies (LU) -- Ignore unavailable to you. Want to Upgrade?

To: Dave who wrote (18568)	8/3/2001 2:52:44 PM
From: GVTucker	Read Replies (2) \| Respond to of 21876

Dave, RE: Assuming that Lucent shoots up to 20, by doing this, the maximum possible loss is the institution faces is the price where the shares were shorted - the conversion price, am I correct? For the most part, yes. But don't forget the 8% coupon plus the interest on the short sale proceeds. If Lucent waits a little while before shooting up to 20, there is no loss. I assume that the hedge fund will want to have equal long convert. exposure to their short exposure, correct? No, not necessarily. It depends on what the fund wants out of the trade. If the fund truly wants zero exposure to the stock, it will probably engage in what is termed as dynamic hedging. When the convert is out of the money like now, the fund will be short fewer than a one to one ratio. The closer the stock gets to the convert price, the more shares are shorted. It gets more complex than that, but the bottom line is that it is an actively managed position intended to eliminate risk if possible. I guess another thing is that the most the institution can loose is approximately 25% (not including the dividend)... Once again, it depends. If the fund is doing a pure cash trade, yes, you're right, as long as you also include the interest on the short. Most funds won't do this, however. The most popular way for a fund to work this trade is to go long the convert and short the common, pocketing the coupon. Then the fund levers the position, on average, about 5 to 1. Some will take it to 10 to 1. The exposure here is the interest rate risk. If rates rise, the converts will decline because the coupon is worth less. Because this would impact the convert much more than the common, the 'arb' trade goes in the wrong direction. If the fund is levered at 5 to 1, equity goes to zero if the convert drops 20%. Boom, the fund blows up.