Convertible arbitragers usually welcome volatility, but not the kind that afflicted their bets Monday on Placer Dome ( PDG).

Common shares of the Vancouver-based gold miner surged 21% after rival Barrick Gold ( ABX) unveiled a $9.2 billion unsolicited bid for its Canadian mining rival. The hostile bid includes a proration formula that is likely to end up paying Placer shareholders 87% of the price in Barrick stock, the rest in cash.

Placer Dome's board said it is considering the offer.

Many holders of the Placer Dome 2.75% convertible bond maturing in 2023 got hurt in the trade. As is often the case in convertible arbitrage, most hedge funds were long the bond and short the underlying stock. On Monday, the appreciation in Placer Dome's stock caused a significant loss on the short side of the trade. Problematically, the rise in the bond wasn't enough to offset that pain.

"The bond is actively quoted, and this is the convertible story of the day," said a trader who has holdings the convertible trade.

The mathematics of convertible arbitrage are esoteric. Roughly speaking, the loss to shorts created by the 21% rise in Placer's common shares was not offset by the 5% gain in the price of its bonds. Traders use models to compensate for the securities' differing volatilities, but in this case, the hedge was less than perfect.

Traders said the price increase in Placer's convertible debt was muted because the proposed deal is a mix of cash and stock. "The maximum amount of cash to be paid by Barrick will be approximately $1.224 billion, and the maximum number of Barrick common shares to be issued will be approximately 303 million, taking into account the conversion of Placer Dome's outstanding convertible debt securities and outstanding share options," according to the press release detailing the bid.

"When it's not clear how much is going to be paid in cash and how much in stock, people over-punish the bond," says Adam Stern, founder of AM Investment Partners, a hedge fund that does not have a position in the trade. Currently, the market assumes that shareholders that shareholders will get paid in stock and bondholders in cash, he said.

The more bondholders get paid in cash, the less advantageous the deal is for them. That's because the option embedded in the convertible security has a greater value when it can capture equity price movements; the premium is reduced when the stock translates into cash.

"Right now, it's a nebulous trade, but we're looking into it," Stern said, adding that the low price of the bond may constitute a buying opportunity once bondholders get clarity on what they would receive.

Using a rough formula based on a typical trade, Stern estimated that the bond price needed to move up to $1,170 per $1,000 of face value in order to offset the surge in stock price. Given that the bond peaked at just over $1,100, he estimates that funds working this arbitrage lost about $7 per hedged bnod.

According to Bloomberg, the largest holders of the Placer Dome convertible paper is hedge fund GLG Partners. Other hedge funds with a position include Marathon Asset Management and Drake Capital Management.

"Most of the action looking forward will be in merger arbitrage," says Bobby Richardson, a convertible portfolio manager with Chapel Hill, N.C.-based hedge fund Argent Financial Group. With the hostile takeover announced, merger arbitragers will come into play, buying the stock of the targeted company and selling short the acquirer. And that's a different trade altogether.

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