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Profitable Price Impact: The Case of Convertible Bond Arbitrage

Last Updated on 10 February, 2024 by Rejaul Karim

Profitable Price Impact: The Case of Convertible Bond Arbitrage,” a research paper by Milad Nozari, Michael Pascutti, and Heather Tookes, delves into a previously unexplored source of profit for convertible bond arbitrageurs – anticipatory hedging in advance of convertible bond issues.

The paper introduces the concept of “profitable price impact” (PPI), which arises from anticipatory short selling in the underlying stock of a bond contract when the reference stock price is determined after a new issue is announced. This price pressure results in an abnormally cheap embedded call option.

Supporting the PPI hypothesis, the study discovers issuer stock price declines on bond pricing days, concentrated during the last hour of trading and followed by partial adjustments. The investigation offers valuable insights into the mechanisms of convertible bond arbitrage and how PPI potentially contributes to arbitrage profits.

Abstract Of Paper

We investigate a potential source of profit to convertible bond arbitrageurs that is new to the literature: anticipatory hedging in advance of convertible bond issues. When the reference stock price in a bond contract is determined after a new issue is announced, anticipatory short selling in the underlying stock can result in “profitable price impact” (PPI). Downward stock price pressure prior to bond pricing creates an abnormally cheap embedded call option. Consistent with PPI, we document issuer stock price declines on bond pricing days that are more concentrated during the last hour of trading and are followed by partial adjustments.

Original paper – Download PDF

Here you can download the PDF and original paper of Profitable Price Impact: The Case of Convertible Bond Arbitrage.

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Author

Milad Nozari
Yale School of Management – International Center for Finance

Michael Pascutti
Yale University; Department of Economics

Heather Tookes
Yale University – Yale School of Management; Yale University – International Center for Finance

Conclusion

In conclusion, the study “Profitable Price Impact: The Case of Convertible Bond Arbitrage” by Milad Nozari, Michael Pascutti, and Heather Tookes brings to light a novel source of profit for convertible bond arbitrageurs – anticipatory hedging before convertible bond issues.

The research uncovers the concept of “profitable price impact” (PPI), which emerges from anticipatory short selling in the underlying stock when the reference stock price is determined post-issue announcement. The resulting downward stock price pressure leads to an abnormally cheap embedded call option.

The findings lend support to the PPI hypothesis by documenting issuer stock price declines on bond pricing days, with the most significant drops occurring during the last hour of trading and followed by partial adjustments. This study significantly enhances the understanding of convertible bond arbitrage dynamics and the role of PPI in driving arbitrage profits.

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FAQ

Q1: What is the key concept introduced in the study, and how does it contribute to convertible bond arbitrage profits?

The study introduces the concept of “Profitable Price Impact” (PPI), which arises from anticipatory short selling in the underlying stock before convertible bond issues. This anticipatory hedging creates downward stock price pressure, resulting in an abnormally cheap embedded call option and contributing to profitable convertible bond arbitrage.

Q2: How is the PPI phenomenon observed in the stock market, and what evidence supports this hypothesis?

The study documents issuer stock price declines on bond pricing days, particularly concentrated during the last hour of trading. These declines are followed by partial adjustments. This observed pattern aligns with the PPI hypothesis, indicating that anticipatory short selling impacts stock prices in the lead-up to convertible bond pricing.

Q3: What are the implications of the research findings for convertible bond arbitrageurs and market participants?

The findings suggest that convertible bond arbitrageurs can benefit from understanding and exploiting the PPI phenomenon. By recognizing the impact of anticipatory hedging on stock prices prior to convertible bond issues, arbitrageurs may enhance their strategies and potentially improve profitability. For market participants, the study provides insights into the dynamics of convertible bond pricing and the factors influencing arbitrage opportunities.

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