poraneous abnormal stock price decline of 1.75% and an ensuing price recovery in the

conversion period. A price fall and the subsequent recovery suggest price pressure as

the explanation for the announcement eect.

In a perfect capital market the option to convert will not be exercised early. The

increase in the number of shares outstanding will then occur at the end of the con-

version period and not at the earlier announcement date. This study's focus is on the

increase in supply that occurs at the announcement day due to short selling of the

calling company's stock. Two groups actively engage in short selling in anticipation of,

and response to, a convertible bond call. Arbitrageurs buy the convertible and short

stock against the equity component of their bond position. Underwriters hedge their

exposure by shorting stock.

This study examines the relation between short selling around a call announcement,

the number of new shares to be issued upon conversion, the predictability ofthe call,

the price reaction to the call announcement, and the subsequent price recovery. We

conclude that short selling induced price pressure explains at least part of the stock

price response to calls. The study's results suggest that an understanding of the stock

price response to convertible bond calls actually requires an understanding of optimal

compensation schemes, risk aversion, and agency problems within the rms that short

sell in response to calls. When short selling by arbitrageurs and underwriters tem-

porarily depresses prices by 1.75%, what are the Shleifer and Vishny (1997) \limits of

arbitrage" that give rise to the bene t of hedging by selling such underpriced stock?

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Paper provided by Copenhagen Business School, Department of Finance in its series Working Papers with number 2001-7.

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Length: 50 pages
Date of creation: 09 Oct 2001
Date of revision:
Handle: RePEc:hhs:cbsfin:2001_007

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Postal: Department of Finance, Copenhagen Business School, Solbjerg Plads 3, A5, DK-2000 Frederiksberg, Denmark
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Related research

Keywords: Convertible bond calls; Short selling; Underwriting; Risk aversion; Limits of Arbitrage;

Find related papers by JEL classification:
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure

This paper has been announced in the following NEP Reports:

• NEP-ALL-2002-04-03 (All new papers)

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