Tail Risk Hedging Using Convertibles

Paul Sansome

This chapter describes one particular tail hedging strategy that is unique in terms of where and how it sources protection – namely, the convertible bond market. It has a live and audited track record from 2006, and was battle-tested in the global financial crisis of 2007–09. Before its most recent incarnation, the strategy was successfully employed as part of a larger fund from the foundation of Ferox Capital in 2000 and in investment bank proprietary trading prior to that.

However, to the uninitiated, the concept of creating a tail hedge with convertible bonds may seem like an oxymoron. After all, convertibles were at the very epicentre of the financial crisis, collapsing to previously unknown levels of distress, with most convertible hedge funds disintegrating. Nevertheless, it was possible to generate large positive returns using one particular convertible strategy – the “synthetic put” – even in 2008. Indeed, the Ferox Bear Fund, which solely pursues this strategy, delivered a very attractive positive return in that year. This chapter sets out how the trade works and the advantages it may have relative to other tail risk strategies.

The strategy in question is not