434 Part IV: Additional Considerations 
underlying stock makes no difference in the eventual outcome. This is generally a 
true statement. However, there are some risks, and they are great enough that one 
can actually lose money in conversions and reversals if he does not take care. The 
risks are fourfold in reversal arbitrage: An extra dividend is declared, the interest rate 
falls while the reversal is in place, an early assignment is received, or the stock is 
exactly at the striking price at expiration. Converters have similar risks: a dividend 
cut, an increase in the interest rate, early assignment, or the stock closing at the strike 
at expiration. 
These risks are first explored from the viewpoint of the reversal trader. If the 
company declares an extra dividend, it is highly likely that the reversal will become 
unprofitable. This is so because most extra dividends are rather large - more than the 
profit of a reversal. There is little the arbitrageur can do to avoid being caught by the 
declaration of a truly extra dividend. However, some companies have a track record 
of declaring extras with annual regularity. The arbitrageur should be aware of which 
companies these are and of the timing of these extra dividends. A clue sometimes 
exists in the marketplace. If the reversal appears overly profitable when the arbi­
trageur is first examining it (before he actually establishes it), he should be somewhat 
skeptical. Perhaps there is a reason why the reversal looks so tempting. An extra div­
idend that is being factored into the opinion of the marketplace may be the answer. 
The second risk is that of variation in interest rates while the reversal is in 
progress. Obviously, rates can change over the life of a reversal, normally 3 to 6 
months. There are two ways to compensate for this. The simplest way is to leave 
some room for rates to move. For example, if rates are currently at 12% annually, one 
might allow for a movement of 2 to 3% in rates, depending on the length of time the 
reversal is expected to be in place. In order to allow for a 2% move, the arbitrageur 
would calculate his initial profit based on a rate of 10%, 2% less than the currently 
prevailing 12%. He would not establish any reversal that did not at least break even 
with a 10% rate. The rate at which a reversal breaks even is often called the "effec­
tive rate" - 10% in this case. Obviously, if rates average higher than 10% during the 
life of the reversal, it will make money. Normally, when one has an entire portfolio of 
reversals in place, he should know the effective rate of each set of reversals expiring 
at the same time. Thus, he would have an effective rate for his 2-month reversals, his 
3-month ones, and so forth. 
Allowing this room for rates to move does not necessarily mean that there will 
not be an adverse affect if rates do indeed fall. For example, rates could fall farther 
than the room allowed. Thus, a further measure is necessary in order to completely 
protect against a drop in rates: One should invest his credit balances generated by the 
reversals in interest-bearing paper that expires at approximately the same time the 
reversals do, and that bears interest at a rate that locks in a profit for the reversal