One of the most widely used convertible bond hedging strategies used by a hedge fund manager is to buy a convertible bond and simultaneously sell short some portion of its underlying equity. Selling short involves selling a borrowed security in the hope of profiting from a drop in its price.

The object of this strategy is to protect against changes in the price of the equity, or short position, while still earning the coupon on the bond, or long position. This position is called a delta-neutral position, because the bond's delta (sensitivity of its price to changes in the price of the underlying stock) is used as a hedge ratio that tells the hedge fund manager how many shares of the equity to sell short.

Bond delta's can range from zero to one. Zero delta is where the bond's price does not move at all when there are price changes in the underlying equity. A delta of one indicates a direct relationship between the value of the underlying equity and the bond (a $1 change in the underlying equity value would result in a $1 change in the bond price for every share the bond is convertible into). The bond's relationship to the underlying equity is described in relation to parity, which is equal to the current stock price, multiplied by the number of shares each convertible bond can be exchanged into.

Convertible bond arbitrage is popular with hedge fund managers because of its high returns and low degree of equity risk relative to other hedge fund strategies. They also favor convertible arbitrage because its performance usually doesn't track the returns of separate equity and fixed income positions.

The crucial element of this strategy is the dollar-neutral, or delta-neutral position, which represents the break-even price. Tracking delta-neutral prices on all positions throughout the day can be a monumental task because of the calculations involved. But its important to know the dollar neutral price when making a bid or receiving an offer on a convertible bond.

Whether you hold convertible bonds in your portfolio directly, or allocate a portion of your investments to a hedge fund that uses convertible bond arbitrage strategies, SS&C's Lightning software can help you perform the portfolio management, compliance, accounting and reporting you will need to monitor these investments.