Hostname: page-component-6bf8c574d5-l72pf Total loading time: 0 Render date: 2025-03-04T04:56:32.469Z Has data issue: false hasContentIssue false
  • English
  • Français

Convertible Debt Arbitrage Crashes Revisited

Published online by Cambridge University Press:  27 April 2023

Craig Lewis ,
Ben Munyan  and
Patrick Verwijmeren
Craig Lewis*
Affiliation:
Vanderbilt University Owen Graduate School of Management
Ben Munyan
Affiliation:
Federal Reserve Bank of Dallas benjamin.munyan@dal.frb.org
Patrick Verwijmeren
Affiliation:
Erasmus School of Economics and University of Melbourne verwijmeren@ese.eur.nl
*
Craig.lewis@Vanderbilt.Edu (corresponding author)
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

This article examines the severity of the 2008 arbitrage crash in the convertible bond market by estimating how expensive it would have been to liquidate portfolio securities immediately. We consider whether funds actually demanded immediate liquidity or were able to delay trades. Our results indicate that the cost of immediacy was high, but that convertible bond sellers could largely avoid selling at fire sale prices. These results can be explained by dealers recognizing when trades are liquidity-motivated rather than information-based and by a shift to riskless principal trading, allowing dealers to avoid taking bonds into inventory.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 4 , June 2024 , pp. 1926 - 1962
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (https://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

The authors thank Hendrik Bessembinder (the editor), Jay Ritter, Christoph Schenzler, Norman Schürhoff (the referee), Li Ting Chiu, and seminar participants at Bocconi University, the Office of Financial Research, the University of Washington, and Erasmus University Rotterdam for helpful comments and discussion.

References

Admati, A. R., and Pfleiderer, P.. “Sunshine Trading and Financial Market Equilibrium.” Review of Financial Studies, 4 (1991), 443–481.10.1093/rfs/4.3.443CrossRefGoogle Scholar
Adrian, T.; Etula, E.; and Muir, T.. “Financial Intermediaries and the Cross-Section of Asset Returns.” Journal of Finance, 69 (2014), 2557–2596.10.1111/jofi.12189CrossRefGoogle Scholar
Agarwal, V.; Fung, W. H.; Loon, Y.-C.; and Naik, N. Y.. “Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market.” Journal of Empirical Finance, 18 (2011), 175–194.10.1016/j.jempfin.2010.11.008CrossRefGoogle Scholar
Ammann, M.; Kind, A.; and Wilde, C.. “Are Convertible Bonds Underpriced? An Analysis of the French Market.” Journal of Banking and Finance, 27 (2003), 635–653.10.1016/S0378-4266(01)00256-4CrossRefGoogle Scholar
Asness, C.; Berger, A.; and Palazzolo, C.. “The Limits of Convertible Bond Arbitrage: Evidence from the Recent Crash. AQR Capital Management White Paper.” CFA Institute Research Foundation. https://www.cfainstitute.org/en/research/foundation/2009/the-limits-of-convertible-bond (2009).Google Scholar
Azarmsa, E., and Li, J.. “The Pricing and Welfare Implications of Non-Anonymous Trading.” Working Paper, University of Chicago (2020).10.2139/ssrn.3576047CrossRefGoogle Scholar
Barclay, M. J.; Hendershott, T.; and McCormick, D. T.. “Competition Among Trading Venues: Information and Trading on Electronic Communications Networks. Journal of Finance, 58 (2003), 2637–2665.10.1046/j.1540-6261.2003.00618.xCrossRefGoogle Scholar
Benveniste, L. M.; Marcus, A. J.; and Wilhelm, W. J.. “What’s Special About the Specialist?” Journal of Financial Economics, 32 (1992), 61–86.10.1016/0304-405X(92)90025-SCrossRefGoogle Scholar
Bessembinder, H.; Carrion, A.; Tuttle, L.; and Venkataraman, K.. “Liquidity, Resiliency and Market Quality Around Predictable Trades: Theory and Evidences.” Journal of Financial Economics, 121 (2016), 142–166.10.1016/j.jfineco.2016.02.011CrossRefGoogle Scholar
Bessembinder, H.; Kahle, K. M.; Maxwell, W. F.; and Xu, D.. “Measuring Abnormal Bond Performance.” Review of Financial Studies, 22 (2009), 4219–4258.10.1093/rfs/hhn105CrossRefGoogle Scholar
Bessembinder, H.; Maxwell, W., and Venkataraman, K.. “Market Transparency, Liquidity Externalities, and Institutional Trading Costs in Corporate Bonds.” Journal of Financial Economics, 82 (2006), 251–288.10.1016/j.jfineco.2005.10.002CrossRefGoogle Scholar
Bloomfield, R.; O’Hara, M.; and Saar, G.. “Hidden Liquidity: Some New Light on Dark Trading.” Journal of Finance, 70 (2015), 2227–2274.10.1111/jofi.12301CrossRefGoogle Scholar
Boehmer, E.; Jones, C. M.; and Zhang, X.. “Shackling Short Sellers: The 2008 Shorting Ban.” Review of Financial Studies, 26 (2013), 1363–1400.10.1093/rfs/hht017CrossRefGoogle Scholar
Brennan, M. J., and Schwartz, E. S.. “Analyzing Convertible Bonds.” Journal of Financial and Quantitative Analysis, 15 (1980), 907–929.10.2307/2330567CrossRefGoogle Scholar
Brown, S. J.; Grundy, B. D.; Lewis, C. M.; and Verwijmeren, P.. “Convertibles and Hedge Funds as Distributors of Equity Exposure.” Review of Financial Studies, 25 (2012), 3077–3112.10.1093/rfs/hhs088CrossRefGoogle Scholar
Calomiris, C. W.; Glosten, L.; and Munyan, B.. “Rents vs. Costs of Intermediation in the Bond Market.” Working Paper, Vanderbilt University (2017).Google Scholar
Chakravarty, S., and Sarkar, S. “Trading Costs in Three U.S. Bond Markets.” Journal of Fixed Income, 13 (2003), 39–48.10.3905/jfi.2003.319345CrossRefGoogle Scholar
Chan, A., and Chen, N.-F.. “Convertible Bond Underpricing: Renegotiable Covenants, Seasoning and Convergence” Management Science, 52 (2007), 1793–1814.10.1287/mnsc.1070.0722CrossRefGoogle Scholar
Choi, D.; Getmansky, M.; Henderson, B., and Tookes, H.. “Convertible Bond Arbitrageurs as Suppliers of Capital.” Review of Financial Studies, 23 (2010), 2492–2522.10.1093/rfs/hhq003CrossRefGoogle Scholar
Choi, D.; Getmansky, M.; and Tookes, H.. “Convertible Bond Arbitrage, Liquidity Externalities and Stock Prices.” Journal of Financial Economics, 91 (2009), 227–251.Google Scholar
Choi, J., and Huh, Y.. “Customer Liquidity Provision: Implications for Corporate Bond Transaction Costs.” Working Paper, University of Illinois at Urbana Champaign (2017).10.17016/FEDS.2017.116CrossRefGoogle Scholar
Chordia, T.; Roll, R.; and Subrahmanyam, A.. “Market Liquidity and Trading Activity.” Journal of Finance, 56 (2001), 501–530.10.1111/0022-1082.00335CrossRefGoogle Scholar
Coval, J. D., and Stafford, E.. “Asset Fire Sales (and purchases) in Equity Markets.” Journal of Financial Economics, 86 (2007), 479–512.10.1016/j.jfineco.2006.09.007CrossRefGoogle Scholar
De Jong, A.; Dutordoir, M.; and Verwijmeren, P.. “Why Do Convertible Issuers Simultaneously Repurchase Stock? An Arbitrage-Based Explanation.” Journal of Financial Economics, 100 (2011), 113–124.CrossRefGoogle Scholar
Dick-Nielson, J. “Liquidity Biases in TRACE.” Journal of Fixed Income, 19 (2009), 43–55.10.3905/jfi.2009.19.2.043CrossRefGoogle Scholar
Dick-Nielson, J.; Feldhutter, P.; and Lando, D.. “Corporate Bond Liquidity Before and After the Onset of the Subprime Crisis.” Journal of Financial Economics, 103 (2012), 471–492.10.1016/j.jfineco.2011.10.009CrossRefGoogle Scholar
Dick-Nielson, J, and Rossi, P.. “The Costs of Immediacy for Corporate Bonds.” Working Paper, Copenhagen Business School (2016).10.2139/ssrn.2787345CrossRefGoogle Scholar
Dugast, J.; Üslü, S; and Weill, P.-O.. “A Theory of Participation in OTC and Centralized Markets.” Review of Economic Studies, 89 (2022), 3223–3266. https://doi.org/10.1093/restud/rdac010.CrossRefGoogle Scholar
Edwards, A. K.; Harris, L. E.; and Piwowar, M. S.. “Corporate Bond Market Transaction Costs and Transparency.” Journal of Finance, 62 (2007), 1421–1451.10.1111/j.1540-6261.2007.01240.xCrossRefGoogle Scholar
Feldhutter, P. “The Same Bond at Different Prices: Identifying Search Frictions and Selling Pressures.” Review of Financial Studies, 25 (2012), 1155–1206.10.1093/rfs/hhr093CrossRefGoogle Scholar
Foucault, T.; Moinas, S.; and Theissen, E.. “Does Anonymity Matter in Electronic Limit Order Markets?” Review of Financial Studies, 20 (2007), 1707–1747.10.1093/rfs/hhm027CrossRefGoogle Scholar
Goldstein, M. A., and Hotchkiss, E. S.. “Providing Liquidity in an Illiquid Market: Dealer Behavior in US Corporate Bonds.” Journal of Financial Economics, 135 (2020), 16–40.10.1016/j.jfineco.2019.05.014CrossRefGoogle Scholar
Goldstein, I.; Jiang, H.; and Ng, David T.. “Investor Flows and Fragility in Corporate Bond Funds.” Journal of Financial Economics, 126 (2017), 592–613.10.1016/j.jfineco.2016.11.007CrossRefGoogle Scholar
Grundy, B. D.; Lim, B., and Verwijmeren, P.. “Do Option Markets Undo Restrictions on Short Sales? Evidence from the 2008 Short-Sale Ban.” Journal of Financial Economics, 106 (2012), 331–348.10.1016/j.jfineco.2012.05.013CrossRefGoogle Scholar
Grundy, B. D., and Verwijmeren, P.. “Disappearing Call Delay and Dividend-Protected Convertible Bonds.” Journal of Finance, 71 (2016), 195–223.10.1111/jofi.12363CrossRefGoogle Scholar
Grundy, B. D., and Verwijmeren, P.. “The Buyers’ Perspective on Security Design: Hedge Funds and Convertible Bond Call Provisions.” Journal of Financial Economics, 127 (2018), 77–93.10.1016/j.jfineco.2017.11.003CrossRefGoogle Scholar
Grundy, B. D.; Verwijmeren, P.; and Yang, A.. “Intermediary Frictions and Asset Pricing.” Working Paper, Australian National University (2022).10.2139/ssrn.4006167CrossRefGoogle Scholar
Harris, L. E. “Transaction Costs, Trade Throughs, and Riskless Principal Trading in Corporate Bond Markets.” Working Paper, University of Southern California (2015).10.2139/ssrn.2661801CrossRefGoogle Scholar
Harris, L. E., and Piwowar, M. S.. “Secondary Trading Costs in the Municipal Bond Market.” Journal of Finance, 61 (2006), 1361–1397.10.1111/j.1540-6261.2006.00875.xCrossRefGoogle Scholar
He, Z.; Kelly, B.; and Manela, A.. “Intermediary Asset Pricing: New Evidence from Many Asset Classes.” Journal of Financial Economics, 126 (2017), 1–35.10.1016/j.jfineco.2017.08.002CrossRefGoogle Scholar
He, Z., and Krishnamurthy, A.. “ Intermediary Asset Pricing.” American Economic Review, 103 (2013), 732–770.10.1257/aer.103.2.732CrossRefGoogle Scholar
Helwege, J.; Huang, J.; and Wang, Y.. “Liquidity Effects in Corporate Bond Spreads.” Journal of Banking and Finance, 45 (2014), 105–116.10.1016/j.jbankfin.2013.08.018CrossRefGoogle Scholar
Hendershott, T.; Li, D.; Livdan, D.; and Schürhoff, N.. “True Cost of Immediacy.” Swiss Finance Institute Research Paper No. 20–71 (2022).Google Scholar
Hong, G., and Warga, A.. “An Empirical Study of Bond Market Transactions.” Financial Analysts Journal, 56 (2000), 32–46.10.2469/faj.v56.n2.2342CrossRefGoogle Scholar
Huang, R. D., and Stoll, H. R. “The Components of the Bid-Ask Spread: A General Approach.” Review of Financial Studies, 10 (1997), 995–1034.10.1093/rfs/10.4.995CrossRefGoogle Scholar
Lee, I.; Verwijmeren, P.; and Wang, R.. “How Do Options Add Value? Evidence from the Convertible Bond Market.” Review of Finance, 27 (2023), 189–222.10.1093/rof/rfac001CrossRefGoogle Scholar
Lesmond, D. A.; Ogden, J. P.; and Trzcinka, C. A.. “A New Estimate of Transactions Costs.” Review of Financial Studies, 12 (1999), 1113–1141.10.1093/rfs/12.5.1113CrossRefGoogle Scholar
Lewis, C. M., and Verwijmeren, P.. “Convertible Security Design and Contract Innovation.” Journal of Corporate Finance, 17 (2011), 809–831.10.1016/j.jcorpfin.2011.03.001CrossRefGoogle Scholar
Li, D., and Schürhoff, N.. “Dealer Networks.” Journal of Finance, 74 (2019), 91–144.10.1111/jofi.12728CrossRefGoogle Scholar
Linnainmaa, J. T., and Saar, G.. “Lack of Anonymity and the Inference from Order Flow.” Review of Financial Studies, 25 (2012), 1414–1456.10.1093/rfs/hhs002CrossRefGoogle Scholar
Loncarski, I.; ter Horst, J.; and Veld, C.. “The Rise and Demise of the Convertible Arbitrage Strategy.” Financial Analysts Journal, 65 (2009), 35–50.10.2469/faj.v65.n5.1CrossRefGoogle Scholar
Madhavan, A. “Security Prices and Market Transparency.” Journal of Financial Intermediation, 5 (1996), 55–83.10.1006/jfin.1996.0015CrossRefGoogle Scholar
Mitchell, M.; Pedersen, L. H.; and Pulvino, T.. “Slow Moving Capital.” American Economic Review, 97 (2007), 215–220.10.1257/aer.97.2.215CrossRefGoogle Scholar
Mitchell, M., and Pulvino, T.. “Arbitrage Crashes and the Speed of Capital.” Journal of Financial Economics, 104 (2012), 469–490.10.1016/j.jfineco.2011.09.002CrossRefGoogle Scholar
O’Hara, M., and Zhou, X. (A.). “Anatomy of a Liquidity Crisis: Corporate Bonds in the COVID-19 Crisis.” Journal of Financial Economics, 142 (2021), 46–68.10.1016/j.jfineco.2021.05.052CrossRefGoogle ScholarPubMed
Rindi, B. “Informed Traders as Liquidity Providers: Anonymity, Liquidity, and Price Formation.” Review of Finance, 12 (2008), 497–532.10.1093/rof/rfm023CrossRefGoogle Scholar
Schestag, R.; Schuster, P.; and Uhrig-Homburg, M.. “Measuring Liquidity in Bond Markets.” Review of Financial Studies, 29 (2016), 1170–1219.10.1093/rfs/hhv132CrossRefGoogle Scholar
Shleifer, A., and Vishny, R. W.. “Liquidation Values and Debt Capacity: A Market Equilibrium Approach.” Journal of Finance, 47 (1992), 1343–1366.10.1111/j.1540-6261.1992.tb04661.xCrossRefGoogle Scholar
Tsiveriotis, K., and Fernandes, C.. “Valuing Convertible Bonds with Credit Risk.” Journal of Fixed Income, 8 (1998), 95–102.10.3905/jfi.1998.408243CrossRefGoogle Scholar
Verwijmeren, P., and Yang, A.. “The Fluctuating Maturities of Convertible Bonds.” Journal of Corporate Finance, 62 (2020), 101576.10.1016/j.jcorpfin.2020.101576CrossRefGoogle Scholar
Zabolotnyuk, Y.; Jones, R.; and Veld, C.. “An Empirical Comparison of Convertible Bond Valuation Models.” Financial Management, 39 (2010), 473–862.10.1111/j.1755-053X.2010.01088.xCrossRefGoogle Scholar
Supplementary material: PDF

Lewis et al. supplementary material

Internet Appendix

Download Lewis et al. supplementary material(PDF)
PDF 287.1 KB