The strategy shorts stocks of firms with convertible bonds on their pricing day, exploiting the predictable stock price decline, excluding stocks priced below $5.
ASSET CLASS: stocks | REGION: Global | FREQUENCY:
Daily | MARKET: equities | KEYWORD: Short Selling, Convertible Bond
I. STRATEGY IN A NUTSHELL
The investment strategy focuses on firms with convertible bonds that were marketed for more than one day, excluding stocks priced below $5. Due to the significant stock price decline observed on the pricing day of convertible bonds, the strategy involves taking a short position on the bond’s pricing day to capitalize on this predictable drop in stock value.
II. ECONOMIC RATIONALE
The paper highlights significant stock price declines on convertible bond pricing days, driven by price pressure from hedging or potential stock manipulation, which may act as complementary forces. Convertible bonds are often issued at incorrect prices, enabling arbitrageurs to profit. Arbitrageurs have little incentive to limit short-selling intensity before bond pricing, as the downward price pressure benefits them through abnormally low strike prices embedded in the bonds. This dynamic results in temporarily inefficient stock prices and a potential wealth transfer from issuing firms to convertible bond buyers. Capitalizing on this phenomenon, short-selling stocks during bond pricing days is profitable, mirroring arbitrageurs’ strategies.
III. SOURCE PAPER
Profitable Price Impact: The Case of Convertible Bond Arbitrage [Click to Open PDF]
Milad Nozari, Michael Pascutti, and Heather Tookes — Yale University; Yale School of Management; International Center for Finance
<Abstract>
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.
IV. BACKTEST PERFORMANCE
| Annualised Return | 2.25% |
| Volatility | 4.47% |
| Beta | N/A |
| Sharpe Ratio | 0.5 |
| Sortino Ratio | N/A |
| Maximum Drawdown | N/A |
| Win Rate | N/A |
