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Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: YanivBA who wrote (56293)	9/14/2006 1:14:59 PM
From: forceOfHabit	Read Replies (1) \| Respond to of 116555

yaniv, "a standard hedge fund debt/equity strategy is, for company's with reasonable default risk, to go long the debt and hedge it with a short position in the stock (or buy puts). You say it is a standard debt/equity strategy. Any idea way this trade works (on normal conditions)?" Sure. One possibility is anytime the bond market is pricing the default risk more conservatively than the stock market, there is an arbitrage opportunity. (The opposite trade, long stocks/short bonds also sometimes occurs). Look at it this way: for healthy companies, the debt trades pretty much uncorrelated to the stock, because a few cents a share more or less in earnings doesn't matter to the debt holders - it all goes to the equity holders. For a company on the edge of default, the bonds and equity are much more tightly correlated because a few pennies per share more in earnings makes the bond holders much more likely to get their principal back. In its most general terms, hedging is just finding two highly correlated assets, buying one (the one that's a little bit underpriced), and selling the other (that's a little bit overpriced). The trade also works as a volatility arbitrage. For that you need to see that the bondholders are short a put: If you think in terms of firm value (some people call it "enterprise value") instead of stock price, you see that the bond holders are short a put to the equity holders, struck at the "bond floor" (i.e. the place where the enterprise value is exactly the value of the outstanding debt). Notice that above this value, its the equity holders that get the upside, and the bondholders get their principal back (no upside). Below this value, the equity holders get nothing (no downside) and the bondholders lose money (until the firm value and the value of their bonds hit 0). This is exactly the return profile you get if you treat equity holders as long the firm value plus a put, and the bondholders short the put. (Alternatively, you could treat the bondholders as long the firm value and short a call, and the equity holders long a call.) OK, if you're still with me, the bondholder is short a put. When would you sell a put? When the implied vol of the put was too high. How would you hedge it? Sell the underlying, e.g. short stock. (A little bit of a fudge at the end their because the actual underlying is firm value not stock, but they are closely related.) "I think bond holders would find the idea of a rewrite a little offensive." I wasn't thinking of existing issues, but future issues. "I think things can get pretty complicated because of problems in the CDS market." For sure. I'll take a look at your prior posts on the topic before I comment. foh