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Department of Finance, Copenhagen Business School Working Paper Series, Department of Finance, Copenhagen Business School

No 2001-7:
Evidence on the Limits of Arbitrage: Short Sales, Price Pressure, and the Stock Price Response to Convertible Bond Calls

Ken L. Bechmann

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?

Keywords: Convertible bond calls; Short selling; Underwriting; Risk aversion; Limits of Arbitrage; (follow links to similar papers)

JEL-Codes: D81; G14; G24; G32; (follow links to similar papers)

50 pages, October 9, 2001

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