Short Selling the Issuer’s Stock in the Convertible Bond Arbitrage
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Profitable Price Impact: The Case of Convertible Bond Arbitrage
Milad Nozari; Michael Pascutti; Heather Tookes
- ?Yale School of Management - International Center for Finance
- Yale University
- ?Department of Economics
- ?Yale University - International Center for Finance
- ?Yale University - Yale School of Management
Strategy in a nutshell
The investment strategy focuses on firms with convertible bonds that were marketed for more than one day, excluding stocks priced below $5. Due to the significant stock price decline observed on the pricing day of convertible bonds, the strategy involves taking a short position on the bond's pricing day to capitalize on this predictable drop in stock value.
Economic rationale
The paper highlights significant stock price declines on convertible bond pricing days, driven by price pressure from hedging or potential stock manipulation, which may act as complementary forces. Convertible bonds are often issued at incorrect prices, enabling arbitrageurs to profit. Arbitrageurs have little incentive to limit short-selling intensity before bond pricing, as the downward price pressure benefits them through abnormally low strike prices embedded in the bonds. This dynamic results in temporarily inefficient stock prices and a potential wealth transfer from issuing firms to convertible bond buyers. Capitalizing on this phenomenon, short-selling stocks during bond pricing days is profitable, mirroring arbitrageurs’ strategies.