To form these hedges, we simultaneously bought the relatively underpriced security while offsetting the risk from adverse changes in its price by selling short the comparatively overpriced security. Since the prices of these two securities tended to move in tandem, I expected the combination to reduce risk while capturing extra returns. I identified these situations using the mathematical methods I had worked out for judging the proper price of a warrant, option, or convertible bond versus the common stock of the same company.
Re: Black-Scholes, looks very likely (or maybe he had even better model? His reticence suggests perhaps?)
But also: when he says “sell short” would that include options (eg buying puts)? Always seemed that actually shorting (borrowing and selling) was expensive and overly risky. What’re the rates on borrowing securities? Expect much higher than interest rates on cash.
