The Rise and Demise of the Convertible Arbitrage Strategy

Do Convertible Bond Issuers Cater to Investor Demand?

“…In the second step of our analysis, we perform cross-sectional ordinary least square (OLS) analyses to test the impact of investor demand proxies on convertible debt prices. Several studies report that the large majority of convertibles are underpriced at issuance (Henderson, 2005;Chan and Chen, 2007;Loncarski, ter Horst, and Veld, 2009;de Jong, Dutordoir, and Verwijmeren, 2011). Potential reasons for convertible debt underpricing include illiquidity, small issue size, and complexities associated with the valuation of hybrid securities (Lhabitant, 2002).…”

“…The residual equity-like part is default free and can be discounted at the risk-free rate. The Tsiveriotis and Fernandes (1998) model is widely used in other academic studies that examine convertible bond underpricing (Ammann, Kind, and Wilde, 2003;Chan and Chen, 2007;Loncarski et al, 2009;de Jong et al, 2011). Zabolotnyuk, Jones, and Veld (2010) point out that the method is also popular among practitioners.…”

“…These funds typically hold a long position in the convertible bond to take advantage of convertible bond underpricing, and hedge this position by shorting the issuer's stock. As demonstrated by Loncarski et al (2009), arbitrage-related short selling results in downward stock price pressure around the convertible bond issuance date. However, de Jong et al (2011) find that the negative issue date price pressure associated with arbitrage-related short selling tends to be short lived as it is caused by an uninformed supply shift that is quickly absorbed by the market.…”

“…We also control for convertible bond credit ratings (obtained from SDC) since Chan and Chen (2007) find higher underpricing for lower rated convertibles. We assign a rating of BAA2 to unrated convertibles, as in Loncarski et al (2009). Consistent with Chan and Chen (2007), we transform the ratings into a numerical CreditRating variable by assigning a value of one to Moody's (Standard & Poor's) Aaa (AAA) ratings and a value of one higher to each subsequent rating.…”

“…We use the following input variables in the Tsiveriotis and Fernandes (1998) model (all measured as of the convertible bond issue date, unless otherwise mentioned): 1) yield on US government bonds in which the maturity most closely matches the maturity of the convertible bond (obtained from CRSP), 2) Moody's credit ratings or equivalent Standard and Poor's ratings (both obtained from SDC). We assign a rating of BAA2 to unrated convertibles, as in Loncarski et al (2009); 3) credit spreads of similarly rated corporate straight debt (obtained from Datastream); 4) conversion ratios and call schedules (obtained from SDC); 5) dividend yield for the fiscal year preceding the issue date calculated as #DCV divided by #MKVALT; 6) price of the underlying stock averaged between trading days −12 and −2 before the issue date (obtained from CRSP); and 7) annualized StockVolatility estimated using daily stock returns over trading days −240 to −40 before the issue date.…”