Good evening,
One of the concerns of convertible bond arbitrage is:
when short selling, shares must be located and borrowed; as a result, the stock owner may subsequently want his/her shares returned at a potentially inopportune time (e.g. when supply for the stock is low or demand for the stock is high)
I thought you own those shares, and don’t need to borrow them? Or how does this work?
Thank you!
C.
You don’t own the shares.
The text never explains why you borrow the shares and sell them, rather than simply buying the bonds, converting them to shares, and selling those shares. I presume that the reason is that the conversion option cannot be exercised immediately, but the text doesn’t say that.
maybe it is cheaper to borrow the shares and maintain a margin account as opposed to outright buying the bond and selling the shares because of commission and bid-ask spread.
Maybe.
Either way, a text that purports to be teaching this stuff should make that explicitly clear.
arbitrage requires no capital investment from the arbitrager. You have to buy the convertible bond in the first place, so you will have to sell something, in this case, it is short selling stocks…
To short sell the shares one needs to maintain a margin account for the situation if short position goes up. Is the amount for maintaining margin account not considered an investment from the arbitrager ?
You are right.
In that case, who has the legal right to get the dvd? lender or the borrower?
In BB 7 on page 37, solution to 3:
The €2 per share borrowing costs and the € 1 dividend payable to the lender together represent a €3 per share outflow that Khan must pay. But, the convertible bond pays a 5% coupon or €50, which equates to an inflow of €1 per share equivalent (€50 coupon/50 shares per bond). Therefore, the total profit outcomes, as indicated in the table, would each be reduced by €2. In sum, Khan would realize a total profit of €4 per each QXR share.
Here, I am confused about who get the dvd and if the borrower gets the dvd, then paying back is not a cost.
Can anyone make it clear for me?
Here is My logic:
The borrower borrows the stock from the lender and simultaneously sells it to a new buyer. The dividend is physically received by the new owner of the stock. There is still a lender who has a claim on the the stock which is lent and a claim on the dividend. To satisfy the lender’s claim on the dividend the borrower must pay the dividend amount from his/her own money. The borrower does not receive the dividend because he/she sold this stock. Thus the dividend amount becomes a cost for the borrower.
Thanks for the explanation. Still. if the borrower do not have ownership of the stock, how can he sell it?
Then the lender does not have a claim on the dividend right?
it’s called a short sale. you sell someone else’s stocks without them noticing. in order to do that, you have to pay all the dividends to the original owner, and you need to later buy the stock and return it to the owner.
why would you do that? you would short sell a stock if you think the stock will go down in price, so that you can later buy at a lower price, resulting in a net profit.
I understand the concept of a short sale. My q here is that who will receive the dividends and who has the ownership of the stock.
If you borrow stock and sell it short, you owe any interim dividends on that stock to the party from whom you borrowed it.
both the original owner and the one who bought it from your short sale own the stock (different shares of the same stock). when you borrow the stock, you do not own the stock. the short sale is a method of selling something that is not yours - by paying any dividends to the original owner and buying the stock back at a later time and returning it to the original owner.
Sorry… What is the fuss all about ?
who gets the dividend
The stock borrower receives the dividends and those dividends the borrower pays to the lender.
The stock borrower does not receive the dividends.
The person to whom the stock borrower sells the shares receives the dividend. The stock borrower has to pay the dividend to the stock lender out of their own pocket.
Oh of course. Silly mistake.
why does the text use the term “arbitrage” for these strategies when they are far from “riskless”
