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