Convertible Arbitrage Price Pressure and Short-Sale Constraints

Using a sample of 4,148 convertibles issued over 1990–2009 by companies listed in 35 countries, the authors exploited worldwide differences in short-sale constraints to examine whether short selling by convertible arbitrageurs creates downward pressure on convertible issuers’ stock prices. They found that short-sale constraints have a positive effect on issue-date abnormal stock returns, which suggests that a substantial part of the stock price effect of convertible issues is attributable to convertible arbitrageurs. Convertible bonds are securities that can be converted, at the option of the holder, into a fixed number of the issuer’s ordinary shares. Convertible arbitrage hedge funds have played an important role in the convertible bond market, especially since the beginning of the 21st century. These hedge funds combine long positions in convertibles with short positions in the underlying stock.We exploited worldwide differences in short-sale constraints to examine whether convertible arbitrage short selling creates downward pressure on convertible issuers’ stock prices. Because arbitrage hedge funds are unable to execute their hedging strategy in markets that are short-sale constrained, we used the existence of short-sale constraints as a proxy for the presence of convertible arbitrage hedge funds in a market. We hypothesized that convertibles issued by companies listed in countries where short selling is legally restricted are associated with more favorable issue-date stock price effects than are convertibles issued in countries where short selling is allowed and practiced. We tested this hypothesis with a sample of 4,148 convertible bonds issued over 1990–2009 by companies listed in 35 countries. In line with our hypothesis, we found that short-sale constraints have a positive effect on issue-date abnormal stock returns. We further found that this effect is stronger in years with higher hedge fund involvement and for offerings expected to induce more arbitrage short selling.In addition, our study maps the global convertible bond market as completely as permitted by publicly available data sources and offers new insights into the determinants of the negative stock price reaction associated with convertible bond offerings. Previous papers have attributed this negative reaction to the signaling content of convertible bond issues. Our approach allowed us to estimate the magnitude of downward price pressure around convertible bond offerings that is attributable to the actions of convertible arbitrageurs rather than to the negative signal inferred from the convertible bond announcement. Our findings suggest that both academics and practitioners who analyze post-2000 convertible bond announcement effects are likely to overstate the negative announcement effects when they fail to control for the short-sale pressure of convertible bond arbitrageurs. On a more general level, our study suggests that stock price behavior around corporate financing events can be substantially affected by short-selling regulations.