Convertible bonds optionality

To access and extract the relatively cheap embedded optionality of the convertible, the manager hedges away other risks that are embedded in the convertible security. These include interest rate risk, credit risk, and market risk. These risks can be hedged using a combination of interest rate derivatives, credit default swaps, and short sales of an appropriate delta-adjusted amount of the underlying stock or, alternatively, the purchase of put options.

Can anyone elaborate on this?

You long the bond and short the convertible shares. You have already elaborated. What exactly is your query ?

My q is that here because the investor has an option to convert, the convertible bond has low coupons right? First of all how is it cheap optionality? second, why do you want to extract the optionality ? I understand that to hedge other risks, we use derivatives.

The convertibility is nothing more than a warrant in place with a ore decided fixed no. of shares per bond instrument. Obviously you buy cheap, higher yield ( hence cheap optionality) . Now going forward you expect the yield to narrow . If the prospects of the bonds improve, the convertible stocks (that seat sub ordinate the bonds) will appreciate … albeit higher.

You exercise your warrant and encash the gains.

Second possibility - The yields rise further thus worsening the prospects of the bonds and the shares. You do not exercise yet your short hedge comes in to play.

Hope things are clearer now.

yes much clearer. Thanks a lot for helping.