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 contemporaneous 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 effect. 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 of the 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 firms that short sell in response to calls. When short selling by arbitrageurs and underwriters temporarily depresses prices by 1.75%, what are the Shleifer and Vishny (1997) \limits of arbitrage" that give rise to the benefit of hedging by selling such underpriced stock?