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Thursday, February 21, 2013 4:42:54 PM
Here's how that arbitrage strategy would work:
An investor both buys the convertible bond AND shorts the stock at the same time. But he buys more convertible bonds than the stocks he shorts. He buys the bonds from the proceeds of the short sale.
If the stock goes up, he loses on the short sale but gains by converting the bond to stock and using it to cover, plus some extra converted shares to take advantage of the up move.
If the stock goes down, then he makes money on his shorts while also getting a juicy interest rate on the bonds which wouldn't convert.
And if the stock does neither go up or go down then he breaks even on the short but makes money from the interest he gets from the bond.
Hence, he would make money regardless of whether the stock goes up, down or sideways. That's why more sophisticated convertible bond issuances have special rules about shorting and converting.
If everyone does the above arbitrage strategy, then there would be a ton of shorting of the stock.
So I agree with you that they should not go down the convertible bond route UNLESS they REALLY understand what they are doing.
Krombacher
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