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

The announcement of a convertible bond call is associated with an average contem- <p> poraneous abnormal stock price decline of 1.75% and an ensuing price recovery in the <p> conversion period. A price fall and the subsequent recovery suggest price pressure as <p> the explanation for the announcement eect. <p> In a perfect capital market the option to convert will not be exercised early. The <p> increase in the number of shares outstanding will then occur at the end of the con- <p> version period and not at the earlier announcement date. This study's focus is on the <p> increase in supply that occurs at the announcement day due to short selling of the <p> calling company's stock. Two groups actively engage in short selling in anticipation of, <p> and response to, a convertible bond call. Arbitrageurs buy the convertible and short <p> stock against the equity component of their bond position. Underwriters hedge their <p> exposure by shorting stock. <p> This study examines the relation between short selling around a call announcement, <p> the number of new shares to be issued upon conversion, the predictability ofthe call, <p> the price reaction to the call announcement, and the subsequent price recovery. We <p> conclude that short selling induced price pressure explains at least part of the stock <p> price response to calls. The study's results suggest that an understanding of the stock <p> price response to convertible bond calls actually requires an understanding of optimal <p> compensation schemes, risk aversion, and agency problems within the rms that short <p> sell in response to calls. When short selling by arbitrageurs and underwriters tem- <p> porarily depresses prices by 1.75%, what are the Shleifer and Vishny (1997) \limits of <p> arbitrage" that give rise to the bene t of hedging by selling such underpriced stock?