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Evidence on the Limits of Arbitrage: Short Sales, Price Pressure, and the Stock Price Response to Convertible Bond Calls

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  • Bechmann, Ken L.

    (Department of Finance, Copenhagen Business School)

Abstract

The announcement of a convertible bond call is associated with an average contem- 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 e ect. 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?

Suggested Citation

  • Bechmann, Ken L., 2001. "Evidence on the Limits of Arbitrage: Short Sales, Price Pressure, and the Stock Price Response to Convertible Bond Calls," Working Papers 2001-7, Copenhagen Business School, Department of Finance.
  • Handle: RePEc:hhs:cbsfin:2001_007
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    File URL: http://openarchive.cbs.dk/cbsweb/handle/10398/7180
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    Keywords

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

    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; Insider Trading
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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