Even wondered how hedge fund managers make their money? No? Well I'm going to tell you anyway. This from The Economist:
A convertible [bond] is, in effect, two financial instruments in one: a bond, plus a call option on the company's shares. Investors pay for the call option by forgoing some interest on the debt. However, companies issuing convertible debt have been selling the option too cheaply. The main determinant of the value of an option is the volatility of the underlying asset over the life of the option. In the case of convertibles, the more volatile the price of shares, the more the option is worth. And companies assumed that their shares would be less volatile than they actually were.Hedge funds have latched on to the opportunity for arbitrage this has thrown up. A hedge fund buys the convertible and sells the debt component, keeping the call option. It then sells the company's shares short, giving it a hedge against movements in the share price. As the share price moves up and down, the fund adjusts its short position, a tactic known as delta hedging. The hedge fund makes money if the shares turn out more volatile than was assumed by the issuer of the convertible.
Got that? Good, now go out and make yourself rich.
Posted by timo at July 22, 2003 06:57 AM | TrackBack