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Derivatives

Convertible Arb Funds Turn To Out-Of-The-Money Puts

Hedge funds have started hedging convertible bonds by buying up cheap, deep out-of-the-money put options as a less risky alternative to shorting stock.

Hedge funds have started hedging convertible bonds by buying up cheap, deep out-of-the-money put options as a less risky alternative to shorting stock. Convertible arbitrage funds are growing wary of short selling as a hedge for the bonds, following losses in May when General Motors Corp.'s stock price rocketed while the debt price fell, explained a hedge fund sales official. Through options, the investor avoids the cost of borrowing the short position and gains leverage on the downside based on the cheap premium paid.

Michael Benhamou, a managing partner with broker-dealer Louis Capital Markets in New York, said the puts are commonly written on autos and airlines with convertible bonds. He said 70,000 inexpensive puts are outstanding on seven million shares of GM, which was trading at around USD35.5 in the spot market last week. About 30,000 puts have been written on three million shares of Ford Motor Co., he added, which stood at USD10.7 last week. And on AMR Corp., the parent company of American Airlines, there is open interest in 90,000 contracts on nine million shares. AMR was trading at USD12.5 last week.

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