Strange trading volumes, page-43

Just a little more on delta-neutral hedging. I'd said its a way of scalping profits. More to the point it is a way for the holder of a convertible note to protect their coupons against changes in the price of the underlying equities. So if this explains the shorting in DLS it means that the convertible note holders are not interested in changes in the price of DLS shares, they practice the neutral hedge strategy to protect their capital invested and rate of interest on their capital. So if I understand it correctly in its simplest form it can be explained as follows: the price of oil falls and so does the price of DLS shares. When the price of DLS shares fall the risk to the convertible bond holder rises as the likelihood of converting the notes to shares falls and the risk of not receiving the full face value of the note at expiry rises, as a consequence the exchange value of the notes falls and their yield rises to reflected the increased risk in holding the notes. So by short selling the underlying DLS shares when their price is falling the note holder compensates for the falling price of the notes and keeps the yield on their notes effectively fixed. If my interpretation is correct its like turning a volatile equity investment into a high yielding fixed income investment. Love to hear any other opinions if you really know how this form of hedging works.

Below is explanation of delta-neutral bond hedging put out by a company who creates portfolio software to manage these type of hedge positions.

Eshmun

Knowing a Bond's Delta-Neutral Position

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.