Chapter 27: Arbitrage 437 
a riskless strategy, such a loss may have the effect of putting them out of business. 
That is an unnecessary risk to take. There are countermeasures, as described above, 
that can reduce the effects of the four risks. 
Let us consider the risks for conversion traders more briefly. The risk of stock 
closing near the strike is just as bad for the conversion as it is for the reversal. The 
same techniques for handling those risks apply equally well to conversions as to 
reversals. The other risks are similar to reversal risks, but there are slight nuances. 
The conversion arbitrage suffers if there is a dividend cut. There is little the 
arbitrageur can do to predict this except to be aware of the fundamentals of the com­
pany before entering into the conversion. Alternatively, he might avoid conversions 
in which the dividend makes up a major part of the profit of the arbitrage. 
Another risk occurs if there is an early assignment on the calls before the ex-div­
idend date and the dividend is not received. Moreover, an early assignment leaves the 
arbitrageur with long puts, albeit fractional ones since they are surely deeply out-of­
the-money. Again, the policy of establishing conversions in which the dividend is not 
a major factor would help to ease the consequences of early assignment. 
The final risk is that interest rates increase during the time the conversion is in 
place. This makes the carrying costs larger than anticipated and might cause a loss. 
The best way to hedge this initially is to allow a margin for error. Thus, if the pre­
vailing interest rate is 12%, one might only establish reversals that would break even 
if rates rose to 14%. If rates do not rise that far on average, a profit will result. The 
arbitrageur can attempt to hedge this risk by shorting interest-bearing paper that 
matures at approximately the same time as the conversions. For example, if one has 
$5 million worth of 3-month conversions established at an effective rate of 14% and 
he shorts 3-month paper at 12½%, he locks in a profit of 1 ½%. This is not common 
practice for conversion arbitrageurs, but it does hedge the effect of rising interest 
rates. 
SUMMARY OF CONVERSION ARBITRAGE 
The practice of conversion and reversal arbitrage in the listed option markets helps 
to keep put and call prices in line. If arbitrageurs are active in a particular option, the 
prices of the put and call will relate to the stock price in line with the formulae given 
earlier. Note that this is also a valid reason why puts tend to sell at a lower price than 
calls do. The cost of money is the determining factor in the difference between put 
and call prices. In essence, the "cost" (although it may sometimes be a credit) is sub­
tracted from the theoretical put price. Refer again to the formula given above for the 
profit potential of a conversion. Assume that things are in perfect alignment. Then 
the formula would read: