Risk and return in convertible arbitrage: Evidence from the convertible bond market

In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds (“CBs”) while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-of-sample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.     

American futures options arbitrage: evidence from the Nikkei 225 options market

Previous studies have examined the profitability of European index options arbitrage. This paper adds to the literature by investigating the arbitrage profitability of American index options—the Nikkei 225 index futures options traded on the Singapore Stock Exchange (SGX). Using the real-time bid–ask prices, we find evidence of profitable arbitrage opportunities, while the frequency of observations violating no-arbitrage bounds and the magnitude of arbitrage profits decrease with the level of transaction costs. Our results have implications for the analysis of American options market efficiency. Failure to use bid–ask prices may lead to biased conclusions.     

The determinants of recovery rates in the US corporate bond market

We examine recovery rates of defaulted bonds in the US corporate bond market, based on a complete set of traded prices and volumes. A study of the trading microstructure around various types of default events is provided. We document temporary price pressure with high trading volumes on the default day and the following 30 days, and low trading activity thereafter. Based on this analysis, we determine market-based recovery rates and quantify various liquidity measures. We study the relation between the recovery rates and these measures, considering additionally a comprehensive set of bond characteristics, firm fundamentals, and macroeconomic variables.     

EMU and European government bond market integration

In this study we adopt the CAPM-based model of Bekaert and Harvey (1995) to compare the differences in the relative importance of two sources of systemic risk (world and Eurozone) on Government bond returns, in two groups of countries in EU-15. Results show that euro markets are less vulnerable to the influence of world risk factors, and more vulnerable to EMU risk factors. However, they are only partially integrated. For their part, the markets of the countries that decided to stay out of the Monetary Union present a higher vulnerability to external risk factors.     

Bond market access and acquisitions: empirical evidence from the European market

We investigate whether access to bond markets affects acquisition activity of the European firms between 1999 and 2014. Our study provides insight into the effect that the growing European bond market has on corporate investment activity. We find that access to the bond markets, measured by the existence of a credit rating, has a significant effect on the tendency of firms to make acquisitions. The effect is strongest in Continental Europe and during times of high acquisition activity. We further find that consistent with prior U.S. evidence, bond market access has an inverse effect on abnormal returns generated by the acquisitions. That finding suggests that firms with superior access to financing pursue targets of lesser quality.     

Why firm access to the bond market differs over the business cycle: A theory and some evidence

This paper presents a theory of firm access to the bond market in which information gathering agencies are valuable but alter the relative cost of bond financing across firms and over the business cycle. The theory builds on the assumption that information frictions prevent these agencies from rating firms correctly all of the time. As a result, the cost of bond financing becomes dependent on the state of the economy and the “quality” of the signal provided by these agencies’ ratings. In addition, when the mix of bond issuers becomes riskier, as happens in recessions, bond financing becomes more expensive for mid-quality firms. Bond financing may even become more expensive to all firms, in which case mid-quality firms will be affected the most. The analysis of the bonds issued in the last two decades by American firms shows that split ratings, our proxy for the “quality” of the rating agencies’ signal, do not affect the relative cost of bond financing across firms in expansions, but they do increase the relative cost of this funding source for mid-credit quality issuers in recessions.     

Networks and equity market integration: European evidence

Deregulation, globalization, and technological developments have altered the business strategies of stock exchanges around the world. We investigate whether the adoption of network strategies by stock exchanges creates additional value in the provision of trading services. Using unbalanced panel data from all major European exchanges over the period 1996-2000, we examine the consequences of network cooperation on a number of stock market performance measures. We show that adopting a network strategy is associated with higher market capitalization, lower transaction costs, higher growth, and enhanced international stock market integration.     

The determinants of short selling: evidence from the Hong Kong equity market

While most financial regulators agree that short sellers have an important role to play in ensuring an efficiently functioning market, it is interesting to note that many did not hesitate to ban short selling during the recent financial crisis. This apparent contradiction most likely stems from a lack of understanding about what motivates short trading. In this paper, we focus on the determinants of short selling during ‘normal’ trading in the Hong Kong stock market. We find that dividend payments, company fundamentals, risk, option trading, the interest rate spread and past returns and short selling are all significant determinants of short selling.     

The impact of bond rating changes on corporate bond prices: New evidence from the over-the-counter market

I study the information content of bond ratings changes using daily corporate bond data from TRACE. Abnormal bond returns over a two-day event window that includes the downgrade (upgrade) are negative (positive) and statistically significant, although the reaction to upgrades is economically small. Monthly abnormal bond returns around downgrades and upgrades are statistically significant but overstate the magnitude of the reaction relative to two-day abnormal returns. Unlike the bond market, the stock market reaction to upgrades is statistically insignificant. Evidence suggests that the differing inferences on the effect of upgrades in the two markets can be attributed to wealth transfer effects rather than relative market inefficiencies. In the cross-section, the bond market response is stronger for rating changes that appear more surprising, rating changes of lower rated firms, and upgrades that move the firm from speculative grade to investment grade.     

Hedge funds as international liquidity providers: evidence from convertible bond arbitrage in Canada

We examine the impact of Canadian convertible bond issuance on equity market liquidity. Using issuance event dates between April 2002 and March 2011, we analyze the change in short interest and stock liquidity during a 1-year event window. We consider mainstream liquidity measures, including turnover, dollar volume, dollar spread, percentage spread, and the ratio of daily absolute stock return to dollar volume. We find that after convertible bond issuances, there are significant increases in short interest, but minimal overall improvements in liquidity. The change in liquidity is not significantly related to the change in short interest, except for the firms with large change in short interest. Interpreting increased short interest after issuance as a proxy for convertible bond arbitrage activity, the results suggest that there is limited positive liquidity externality of hedge fund activity in Canada.     

Sovereign risk premiums in the European government bond market

This paper provides a study of bond yield differentials among EU government bonds on the basis of a unique data set of issue spreads in the US and DM (Euro) bond market between 1993 and 2009. Interest differentials between bonds issued by EU countries and Germany or the USA contain risk premiums which increase with fiscal imbalances and depend negatively on the issuer’s relative bond market size. The start of the European Monetary Union has shifted market attention to deficit and debt service payments as key measures of fiscal soundness and eliminated liquidity premiums in the euro area. With the financial crisis, the cost of loose fiscal policy has increased considerably.     

Collateral affects return risk: evidence from the euro bond market

Covered bonds and senior bonds are prominent securities in the euro bond market. Senior bonds are unsecured, while covered bonds are secured—backed by collateral. Our results show that the presence of collateral reduces the total risk in individual bonds by more than 70%. Compared to diversified portfolios of senior bonds, diversified portfolios of covered bonds have a significantly lower level of systematic risk. However, the fraction of systematic risk to total risk is higher for covered bonds. By decomposing the variance of bond returns, we find that around 33% of the risk in senior bonds is systematic, versus 53% in covered bonds. Both types of bonds contain instrument-specific risk.

     

Measurement of market integration and arbitrage

We develop a measurement theory of market integration, basedon two notions of 'integrated markets'. First, two markets cannotbe perfectly integrated in any sense if one can construct twoportfolios, one from each market, that have identical payoffsbut different prices. In that case, the law of one price isviolated across the markets. Second, they cannot be integratedin a stronger sense if there are cross-market arbitrage opportunities.Two measures of market integration are developed, respectivelyreflecting these notions. The smaller the measures, the moreclosely integrated (in the respective senses) the markets. Amongother things, they are interpreted as measuring pricing discrepancybetween markets.     

The information content of credit ratings: evidence from European convertible bond markets

Prior research has investigated the information content of credit ratings for standard financing instruments such as stocks and corporate bonds, while this question has been neglected for convertible bonds (CBs) so far. CBs are simultaneously determined by the bond floor and the conversion value, which makes it more difficult to assess price effects following rating announcements. In this context, we compare price effects of CBs with those of stocks and corporate bonds of the same issuer using robust event study methods. Our findings indicate that rating changes convey new information for investors in European CBs. In terms of the direction of the expected price reaction, we find CBs to react in a more debt-like manner to the announcement of a rating change. Moreover, our results provide evidence that the magnitude of price reactions differs among different types of securities.     

Liquidity and price pressure in the corporate bond market: evidence from mega-bonds

Larger bonds offer greater liquidity, which should reduce their yields. A simple way for firms to reduce financing costs is to sell bonds with large face values. We find that mega-bonds are more liquid than smaller bonds. However, offering yield spreads on mega-bonds are not lower and are higher than spreads of bonds issued by similar companies. The discount applied to large new issues is consistent with price pressure effects that are also present in the secondary market prices of the issuing firm's existing bonds. Our results suggest a hidden cost to issuing very liquid bonds.     

Overcoming limits of arbitrage: Theory and evidence

Limits to arbitrage arise because financial intermediaries may face funding constraints when mispricing worsens. Using a model with limits to arbitrage, where we allow arbitrageurs to secure capital even in case of underperformance, we show that arbitrageurs that are more protected from withdrawals have more mean-reverting and volatile returns. Using data on hedge fund performance, we find robust support for these hypotheses: Funds with contractual impediments to withdrawals, and funds with performance-insensitive outflows, recover more quickly after a bad year and have more volatile returns. Our evidence is consistent with the idea that some hedge funds overcome the limits to arbitrage.     

Evolution of international stock and bond market integration: Influence of the European Monetary Union

This paper examines the dynamic relationship between daily stock and government bond returns of selected countries over the past decade to infer the state and progress of inter-financial market integration. We proceed to empirically investigate the influence of the European Monetary Union (EMU) on time variations in inter-stock–bond market integration/segmentation dynamics using a two-step procedure: First, we document the downward trends in time-varying conditional correlations between stock and bond market returns in European countries, Japan and the US. Second, we investigate the causality and determinants of this interdependent relationship, in particular, whether the various macroeconomic convergence criteria associated with the EMU have played a significant role. We find that real economic integration and the reduction in currency risk have generally had the desired effect on financial integration but monetary policy integration may have created uncertain investor sentiments on the economic future of the EMU, thereby stimulating a flight to quality phenomenon.     

Multivariate regression tests of the arbitrage pricing theory: The instrumental-variables approach

This article expands the theoretical basis upon which empirical testing of the arbitrage pricing theory (APT) rests. Specifically, it specifies linear restrictions for worlds in which the APT holds. These restrictions may, in principle, be tested. Since the regressors in the model are only “noisy” proxies for a specific linear transformation of the factors or mimicking portfolios, testing regressions suffer from an errors-in-variables problem. The standard econometric treatment for this problem is the instrumental-variables approach. A size-based example is employed to compare the test results derived from the instrumental-variables approach to those obtained via the ordinary least squares (OLS) method. The results from both methods cannot reject a two-factor APT for the size-sorted portfolio sample. The authors appreciate the helpful comments of Edwin Burmeister, Raymond Chiang, Steve Pruitt, participant at the 1989 Western Finance Association annual meetings, Indiana University, and University of Miami, and especially Shmuel Kandel.