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This episode aired on Bloomberg TV on Nov 21, 2012

Delta-Neutral Hedge

Q. What’s a Delta Neutral Hedge?

A. It’s at the core of several hedge fund strategies, specifically convertible bond arbitrage. To understand the term, the first point is to understand “Delta”. That term refers to the relationship between the price movement of a stock, and the price movement of a derivative related to that stock.

Q. So, you mean like stocks and the associated puts or calls?

A. Yes, exactly, and those are good examples to illustrate the point. You can imagine that a call option on a stock becomes more valuable as the stock goes up… but the question is, in what ratio? If the call is way out of the money, it won’t go up $ for $ with the stock. But it’s deep in the money, and especially where the option is close to expiration, then it generally will. But whatever that ratio is, we call the delta, or sometimes the “hedge ratio”.

Q. I see. So the Delta ratio of a fund then refers to how much the overall fund will move, taking into account all its stock and derivative positions, as stock prices bounce around?

A. Right. And the idea of a Delta Neutral Hedge also becomes clear now: it describes a portfolio that, in principle, does not change value as underlying stocks in it move up or down.

Q. Lovely. But… why would I want to construct a portfolio like that? Since I’m paying a big management fee, I’d sort of like to make a profit…

A. You’re awfully picky. But you can see the value of a Delta Neutral Hedge strategy in the convertible bond world; in fact, although there are several flavors of convertible bond arbitrage, “Delta Neutral Hedges” are the bread and butter of the industry. Very, very basically, with this approach, we can buy the convertible bond and sell the underlying stock in a way that makes us stock market neutral. But, meantime, we’re capturing the income from the bond and the short sale proceeds. And, as David Rich explained in the first segment today, good traders can also profit from the long volatility exposure that that is isolated by this strategy.