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