Also known as a reverse hedge, a Chinese hedge is a strategy that involves assuming a short position with convertible securities while at the same time going with a long position with the underlying assets associated with those securities. The idea of this type of investment approach is to take advantage of situations where those underlying assets will decrease in value, which in turn helps to make that short position on the securities more profitable. Structuring a Chinese hedge requires projecting the movement on those underlying assets in order to determine if there is the potential for a drop, or if the assets are likely to hold their value for at least the short term.
One of the reasons that the Chinese hedge is sometimes referred to as a reverse hedge is that the focus is on what is expected to happen with the underlying asset. This is different from other types of hedge strategies, where the focus is on the performance of the security and not the underlying asset. Unlike other investment approaches, this type of convertible arbitrage actually depends on the asset losing value in order for the investor to realize a return.
One way to understand how a Chinese hedge works is to consider the purchase of a convertible bond. With this type of bond, there is the option to eventually convert the issue into shares. The investor will buy the bond and also buy the stock that serves as the underlying asset for the bond. If all goes as planned, what will happen is that the conversion premium will appreciate, allowing the investor to earn a higher return for the short position.
There is some degree of risk with a Chinese hedge. Should the underlying stock rise, this would actually make the price of the convertible rise, which in turn causes the conversion premium associated with the strategy to be less rewarding. The end result is that the investor does not realize much of a profit from the strategy, or may not realize anything at all.
For the most part, a Chinese hedge is considered to be a relatively safe investment. Unusual shifts in the value of the underlying asset would be necessary to prevent the investor from at least breaking even. If an investor can look closely at upcoming events and other factors that are likely to exert some influence on the movement of the underlying asset, and accurately predict the type of impact that will take place, it is possible to identify the right investment and underlying asset to utilize with this type of strategy.
