The announcement of an in-the-money convertible bond call is ass ociated with an a verage con temporaneous abnormal stock price decline of 1.75% and an ensuing price recovery in the conversion period. This paper argues and provides evidence that the decline in stock prices is due to investors short selling of the underlying stock at or around the call announcement. Two types of investors have incentives to hedge their equity exposure by short selling at the time of the call. First, the convertible hedge desks of investment banks try to lock in arbitrage protsby buying the called convertible bond and short selling the underlying stock. Short selling is used to hedge the equity risk of the convertible bond because the option to convert is not exercised immediately. Second, a possible underwriter of the call also short sells in order to hedge the equity risk associated with the call. The short selling of stock by these two types of investors, at least in part, causes the short-run price pressure.
In order to provide evidence for such hedging, this paper contains the rstanalysisof short selling around calls of convertible securities. More precisely, this paper examines the relationship between short selling, trade volume, the predictability of the call, the stock price reaction to the call announcement as well as variables related to hedging.
This paper shows that the short selling of stock increases in anticipation of the call and that during the conversionperiod, then umber of shares sold short is more than three times higher than after the call. On average, the total short selling involves at least 19%of the new shares to be issued upon conversion, which corresponds to nearly 14 days of trading based on the average trade volume before the call.
In addition, the paper provides evidence of a large increase in the trade volume at the announcement of the call, and shows that this trade volume is related to then umber of new shares to be issued upon conversion of the bonds. Such an increase in trade volume, at least partly due to short selling, is likely to depress stock prices, thus causing the short-run price pressure around convertible bond calls. Furthermore, the paper shows that short selling is not solely caused byapossible underwriter. Finally, the paper shows that the relationship between the announcementeect and several variables describing the call is also consistent witha hedging induced price pressure.
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Short sales, price pressure, and the stock price response to convertible bond calls
