The Rise and Demise of the Convertible Arbitrage                     Strategy

Lončarski, Igor; Horst, Jenke ter; Veld, Chris

doi:10.2469/faj.v65.n5.1

Cited by 67 publications

(51 citation statements)

References 27 publications

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“…A limited number of studies investigate short-selling using non-US data (e.g. Aitken et al, 1998, Biais et al, 1999, Poitras, 2002, Ackert and Athanassakos, 2005, Au et al, 2007, Loncarski et al, 2009. However, these studies do not involve an investigation into short covering, as considered in this paper.…”

Section: Datamentioning

confidence: 99%

Short-Sellers and Short Covering

Moles¹,

Clunie

Pyatigorskaya

2009

MFJ

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This study fills an important gap in the literature on loss realization aversion. It shows how a 'sophisticated' sub-set of investors, namely short-sellers, react to losses. Using daily data on stock lending, we estimate the average price at which short positions were initiated, thus permitting a study of short-sellers' responses to their own book losses. We find that shortsellers close their positions in response to losses and not simply in response to rising share prices. This is a key result and a distinction from findings in related research. We conclude that short-sellers do not exhibit an aversion to realizing losses, but instead accept their losses or 'mistakes' systematically. Stocks subject to short-covering in this manner do not subsequently under-perform the market, and so there is no evidence of an investment performance cost (other than transaction costs) associated with immediately covering short positions that fall to an accounting loss. As short-sellers are believed to play an important role in the setting of prices, the results of this study have implications for asset pricing and market efficiency. 3 IntroductionThere is no upper limit to the price at which a stock can trade. Consequently, there is no limit, in theory, to the amount of money that a short-seller can lose. This contrasts with the experience of long-only investors, where losses are limited to the amount of capital invested.Exposure to unlimited liability can have catastrophic consequences, including personal bankruptcy, and is thus an important consideration in risk management. In this paper, we use a relatively new commercial dataset to examine the response of short-sellers to losing positions. We find significant evidence that short-sellers cover their positions as losses grow.This is consistent with short-sellers' use of stop losses as a risk control mechanism. We relate our findings to the literature on loss realization aversion and the 'disposition effect', an observed regularity in many studies of investor behavior. Our evidence that short-sellers are not averse to realizing losses has important implications for asset pricing and market efficiency, providing a strong motivation for this research.The literature on behavioral finance describes a number of investor biases, or apparent divergences from rational behavior. Amongst these is the tendency for investors to hold on to their losing stocks too long and sell their winners too early. Shefrin and Statman (1985) call this the 'disposition effect'. They seek to explain it by combining 'prospect theory' (Kahneman and Tversky, 1979) with the notion of 'mental accounting' (Thaler, 1985).Prospect theory modifies expected utility theory in two ways. It suggests that individuals assess outcomes through the change they bring to their current situation (or other reference state) and not through their effect on overall wealth; and that utility functions are concave for gains and convex for losses (but steeper to attain overall risk aversion). Thus, losses (from a reference sta...

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Section: Datamentioning

confidence: 99%

Short-Sellers and Short Covering

Moles¹,

Clunie

Pyatigorskaya

2009

MFJ

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“…Therefore, some authors, such as Ammann et al (2003), Loncarski et al (2009), Zabolotnyuk et al (2010, have to make do with historical volatilities. Similarly, we calculate the historical volatility as the annualized standard deviation of the daily log returns over the last 2 years (from September 10, 2010 to September 10, 2012), and then value the convertible bond based on this real-world volatility.…”

Section: Convertible Bond Case 1 (A 7-year Convertible) Case 2 (A 20-mentioning

confidence: 99%

“…In fact, it is believed that hedge funds purchase 70% to 80% of the convertible debt offered in primary markets. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing (i.e., the model prices are on average higher than the observed trading prices) (see Ammann et al (2003), Calamos (2011), Choi et al (2009), Loncarski et al (2009, and so on). However, Agarwal et al (2007) and Batta et al (2007) argue that the excess returns from convertible arbitrage strategies are not mainly due to underpricing, but rather partly due to illiquid.…”

Section: Introductionmentioning

confidence: 99%

“…However, most liquid stock options have relatively short maturates (rarely more than 8 years). As a result, some authors, such as Ammann et al (2003), Loncarski et al (2009), Zabolotnyuk et al (2010), have to make do with historical volatilities. Therefore, we segment the sample into two sets according to maturity: a short-maturity class (0 ~ 8 years) and a long-maturity class (> 8 years).…”

Section: Introductionmentioning

confidence: 99%

“…A typical convertible bond arbitrage employs delta-neutral hedging, in which an arbitrageur buys a convertible bond and sells the underlying equity at the current delta (see Choi et al (2009), Loncarski et al (2009, and so on). With delta neutral positions, the sign of Gamma is important.…”

Section: Introductionmentioning

confidence: 99%

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Why do companies issue convertible bond loans? An empirical analysis for the Canadian market

2008

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To identify issuer motives, we study the determinants of announcement effects of convertible debt issues in the Canadian market. Classified into equity- and debt-like, wealth effects are significantly more negative for equity-like convertible bond issuers. Equity-like convertibles are significantly negatively affected by agency costs of equity. However, agency costs of debt have no significant effect on debt-like convertibles. Consistent with Stein (1992), this suggests convertibles in particular represent a substitute for equity. Moreover, convertible debt offers announced by income trusts experience significantly less negative wealth effects than offers by nontrusts - a finding explained by a more debt-like convertible design, very low agency costs of equity in case of income trusts, or both

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The Rise and Demise of the Convertible Arbitrage Strategy

Cited by 67 publications

References 27 publications

Short-Sellers and Short Covering

Short-Sellers and Short Covering

A simple and precise method for pricing convertible bond with credit risk

Why do companies issue convertible bond loans? An empirical analysis for the Canadian market

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