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Chapter 25: Senior Securities with Warrants, Participating Issues, Switching and Hedging

It is sometimes possible in convertibles that an absolutely dependable conclusion can be arrived at by security analysis. Thus it makes for a scientific application of security analysis in some situations.

When there is a senior issue convertible into common, the concentration of speculative interest in the latter often results in establishment of a price level closely equivalent to the price of the senior issue, to which the public pays little attention. A convertible issue selling at parity with the common is preferable thereto, except when its price is so far above an investment level that it has become merely a form of commitment in the common stock. It is generally worthwhile to pay some moderate premium in order to obtain the superior safety of the senior issue. This is certainly true when the convertible yields a higher income return than the common, and it holds good to some extent even if the income yield is lower.

Thus as a practical rule, holders of common stocks who wish to retain their interest in the company should always exchange into a convertible issue of the enterprise, whenever it sells both at an investment level on its own account and also close to parity on a conversion basis.

Graham has a few suggestions on hedging:

  1. Ability to borrow stock sold and to maintain short position indefinitely.
  2. Original cost of establishing position, including spread and commissions.
  3. Cost of maintaining the position, including interest charges on long holdings, dividends on short stock, possible premiums payable for borrowing stock, and stamp taxes in connection with reborrowing of stock – less offsets in the form of dividends or interest receivable on long securities and possible interest credit on short position.
  4. Amount of profit at which operation will probably be closed out if opportunity offers. Relationship between this maximum profit and probable maximum loss, consisting of (2) plus (3).

The profit potential to be taken into account is not the maximum figure that might conceivably be reached but merely the highest figure for which the operator is likely to wait before he closes out his position.

Hedging operation: One potential approach consists of purchasing a convertible issue and selling only part of the related common shares, say, one-half of the amount receivable upon conversion. On this basis a profit may be realized in the event of either a substantial advance or a substantial decline in the common stock. This is probably the most scientific method of hedging, since it requires no opinion as to the future course of prices. An ideal situation of this kind should meet the following two requirements:

  1. A strongly entrenched senior issue that can be relied on to maintain in price close to par even if the common should drop precipitately. A good convertible bond, maturing in a short time, is an ideal type for this purpose.
  2. A common stock in which the speculative interest is large and that therefore subject to wide fluctuations in either direction.

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