Short Selling Activities and Convertible Bond Arbitrage: Empirical Evidence from the New York Stock Exchange

268 Pages·2010·1.37 MB·English

by  Sebastian P. Werner (auth.)

Sebastian P. Werner
Short Selling Activities and Convertible Bond Arbitrage
GABLER RESEARCH
EBS Forschung
Schriftenreihe der European Business School (EBS)
International University · Schloss Reichartshausen
Herausgegeben von
Univ.-Prof. Ansgar Richter, PhD
Band 75
Die European Business School (EBS) – gegründet im Jahr 1971 – ist Deutschlands
älteste private Wissenschaftliche Hochschule für Betriebswirtschaftslehre im Univer-
sitätsrang. Dieser Vorreiterrolle fühlen sich ihre Professoren und Doktoranden in For-
schung und Lehre verpfl ichtet. Mit der Schriftenreihe präsentiert die European Busi-
ness School (EBS) ausgewählte Ergebnisse ihrer betriebs- und volkswirtschaftlichen
Forschung.
Sebastian P. Werner

Short Selling Activities
and Convertible Bond Arbitrage

Empirical Evidence
from the New York Stock Exchange
With a foreword by Prof. Dr. Lutz Johanning
RESEARCH
Bibliographic information published by the Deutsche Nationalbibliothek
The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografi e;
detailed bibliographic data are available in the Internet at http://dnb.d-nb.de.
Dissertation European Business School, International University Schloss Reichartshausen,
Oestrich-Winkel, 2009
D 1540

1st Edition 2010
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V
Foreword
The main cause of financial crisis may be found in the over-optimistic investing of buy-
ers that leads market prices away from fundamental values. However, in the aftermath
of “excess” when stock markets tumble, it is usually the pessimists or short sellers who
get publicly blamed. Despite the longstanding controversy on short selling activities,
this market instrument remains a widely misunderstood concept by the public while it is
an essential tool used by hedge funds for speculation and arbitrage. That is why it is
important to investigate short selling for its different motivations and the resulting effect
on stock returns, a subject whose empirical study is in its infancy.

In his doctoral thesis, Sebastian examines convertible bond arbitrage, which is a
typical hedge fund strategy that involves a long position in a convertible bond and a
significant short position in the underlying stock. The short selling is employed as a
hedge against movements in the stock price. With every change in the stock price, the
hedge needs to be continuously readjusted, a practice which should lead companies with
convertible bonds outstanding to have on average higher short selling activity than
companies without convertible bonds. Furthermore, fundamental information should be
processed differently in stocks with convertible bonds as stock price reactions based on
the information are accompanied by the short selling of the convertible bond arbitra-
geurs. Developing and investigating these predictions, Sebastian focuses on events of
extreme stock price changes and short selling activity when the presence and differences
in the effect on stock returns of arbitrage and speculation based short selling should be-
come most apparent. The results document the predicted patterns and are strongest for
firms with convertible bonds whose embedded equity options trade at-the-money. These
insights hold important implications for the interpretation of aggregate short selling ac-
tivity. They are also relevant for the explanation of the stock price pattern of firms that
have issued similar instruments of external financing or that are subject to the issuance
of derivative products such as in the case of structured retail products.

With his innovative research framework, excellent presentation of the empirical
analysis and insightful discussion of the dynamics of short selling and convertible bond
arbitrage, I wish that researchers, regulators and practioners will acknowledge Sebas-
tian’s contribution to the ongoing debate of the role and effect of short selling activities
in financial markets.

Johannisberg, April 2009 Prof. Dr. Lutz Johanning
VII
Acknowledgements
„If you want to win something, run 100 meters. If you want to experience something,
run a marathon.”
Emil Zatopek – Triple Olympic Gold Medalist 1952 (5k, 10k, Marathon)
Writing this dissertation has been like running a marathon. Passing all stages of training,
stepping up to the starting line, hitting the wall, and accelerating to force the finishing
kick until crossing that finish line would not have been possible without the great sup-
port and advice of my supervisors, inspirers, coach, friends and family. To them I owe a
large debt of gratitude.

I am most indebted to Lutz Johanning, my doctoral supervisor at the Endowed Chair
of Asset Management at European Business School (EBS). He provided me with the
highest possible degree of freedom in finding my research area of interest. Most impor-
tant, he created a learning environment for innovative thought and open discussion
among us doctoral students, which made all the difference. I thank him for his continu-
ous encouragement, for the experience I gained by assisting and teaching lectures in
asset management and financial risk management at EBS and the opportunity to spend a
semester abroad in the Finance PhD program of the Katz Graduate School of Business,
University of Pittsburgh.
I appreciate the help and support of Rolf Tilmes, my co-supervisor. I am thankful for
his constructive feedback and second opinion during my annual proposal defenses and
for keeping me away from irrelevant empirical battlefields.

I was fortunate and blessed to have had the opportunity to spend time with Gershon
Mandelker from Katz and Yakov Amihud from the Stern School of Business, New
York University, who have both had a great influence on my research aspiration. I am
very thankful for their words of wisdom and the guidance they provided.

My special appreciation goes to my colleagues and friends Timo Gebken, Christian
Funke and Gaston Michel. I am grateful for their intellectual spirit, interest, patience
and practical advice on the big picture as well as on the details. All three of them have
played essential roles in helping me get to the finish line and making the experience
worthwhile.
I would also like to thank my former colleagues Martin Ahnefeld, Benjamin Kleidt,
Markus Mentz, Christian Voigt and Felix Zeidler from the Endowed Chair of Banking
and Finance for a memorable time and vibrant discussions during coffee breaks and
barbecuing sessions. Many thanks also to Trudel Thullen, our secretary, for setting a
standard in service and quality to our students and sponsors and especially for her big
heart and Rüdesheimer Kaffee.
VIII Acknowledgements
I am grateful to another very influential person that held a torch in the tunnel of
darkness. Vera Bloemer, my coach during the EBS Doctoral Coaching Program, asked
me the right questions which made me find the right answers, a process that had more
effect in keeping me on track than she may have realized.

Running as well as writing is a lonely pleasure, and a small amount of other people’s
enthusiasm can have disproportionately large and beneficial impact. This relates espe-
cially to my personal Band of Brothers who have been long-time companions on this
and the other side of the ocean. Heartfelt thanks to Georg Altenkirch and Patrick Heine-
mann who suffered alongside in similar fields of research and who have been great bud-
dies since the early days of my studies at EBS. I thank Philipp Wegener for creating the
vision of pursuing a doctoral degree as we sat in his backyard one sunny afternoon,
which set the initial spark for this endeavour. Moreover, for great times, wanted distrac-
tion from work and never-ending words of encouragement, I am thankful to Philipp
Cordes, Philipe and Petra Gerlach, Rahul Handa, Volker Kortholt, Alexander Köth,
Dennis Lübcke, Chandra Prasad and Basil Petrov, Norbert Stangelmayer, Vittal Wag-
ner, Luke and Lindsay Warford.

Finally, above all, I am pleased to thank my parents and my grandmother for their
unyielding belief in me. Especially my parents’ emotional as well as financial support
gave me the necessary strength, peace of mind and motivation to finish this doctoral
thesis. To them I dedicate this work.

Oestrich-Winkel, April 2009 Sebastian Werner
IX
Overview
List of Tables..............................................................................................................XV
List of Figures..........................................................................................................XVII
List of Abbreviations...............................................................................................XIX
1 Introduction........................................................................................................1
1.1 Background and Objective.............................................................................1
1.2 Organization of the Dissertation.....................................................................2
2 Background and Empirical Predictions...........................................................7
2.1 Short Selling...................................................................................................7
2.2 Convertible Bond Arbitrage.........................................................................29
2.3 Empirical Predictions...................................................................................45
3 The Event Study Methodology........................................................................53
3.1 Relevance of the Methodology for the Empirical Investigation...................53
3.2 Outline of an Event Study............................................................................54
3.3 Estimation of Abnormal Returns..................................................................56
3.4 Estimation of Abnormal Short Selling Activity...........................................59
3.5 Hypotheses Testing......................................................................................63
3.6 Summary......................................................................................................66
4 Data, Full Sample and Variable Construction...............................................67
4.1 Data Sources.................................................................................................67
4.2 Full Sample Construction.............................................................................70
4.3 Variable Construction..................................................................................71
4.4 Summary......................................................................................................76
5 Difference in Abnormal Short Selling Activity Following Events of Large
Positive Stock Price Changes...........................................................................79
5.1 Measuring the Difference in Abnormal Short Selling Activity....................79
5.2 Investigating Abnormal Short Selling Activity..........................................109
5.3 Conclusion.................................................................................................143
6 Difference in Information Content of Extreme Short Selling Activity
Events and the Impact on Stock Returns.....................................................145
6.1 Measuring the Difference in Information Content......................................145
6.2 Investigating the Impact on Stock Returns.................................................175
6.3 Conclusion.................................................................................................195
7 Overall Conclusion.........................................................................................197
Appendix.....................................................................................................................201
References...................................................................................................................245
XI
Table of Contents
List of Tables..............................................................................................................XV
List of Figures..........................................................................................................XVII
List of Abbreviations...............................................................................................XIX
1 Introduction........................................................................................................1
1.1 Background and Objective.............................................................................1
1.2 Organization of the Dissertation.....................................................................2
2 Background and Empirical Predictions...........................................................7
2.1 Short Selling...................................................................................................7
2.1.1 Foundations................................................................................................7
2.1.1.1 General Mechanics and Institutional Details of Short Sales in U.S.
Equity Markets......................................................................................7
2.1.1.2 A Change to U.S. Short Selling Regulation – Regulation SHO..........11
2.1.1.3 Motives for Short Selling Activities....................................................14
2.1.1.4 Market Development of Short Sales in Recent Years.........................15
2.1.2 Literature Review on Short Selling..........................................................17
2.1.2.1 Theoretical Work.................................................................................17
2.1.2.2 Empirical Evidence.............................................................................18
2.1.2.2.1 Information Content of Short Sales.............................................18
2.1.2.2.2 Arbitrage-Based Short Selling.....................................................21
2.1.3 Determinants of Short Selling..................................................................23
2.1.3.1 Valuation.............................................................................................23
2.1.3.2 Arbitrage and Hedging........................................................................24
2.1.3.3 Short Sale Constraints.........................................................................26
2.1.4 Summary..................................................................................................27
2.2 Convertible Bond Arbitrage.........................................................................29
2.2.1 Convertible Bonds....................................................................................30
2.2.1.1 Theoretical Foundations and Terminology..........................................30
2.2.1.2 Delta and Gamma................................................................................34
2.2.2 The Convertible Bond Arbitrage Strategy................................................37
2.2.3 Historical Performance and Market Activity............................................42
2.2.4 Literature Review on Convertible Bond Arbitrage and Short Selling
Activity....................................................................................................44
XII Table of Contents
2.2.5 Summary..................................................................................................45
2.3 Empirical Predictions...................................................................................45
2.3.1 Research Objective and Propositions.......................................................46
2.3.2 Difference in Trading Pattern...................................................................47
2.3.3 Difference in Information Content and Impact on Stock Returns............48
3 The Event Study Methodology........................................................................53
3.1 Relevance of the Methodology for the Empirical Investigation...................53
3.2 Outline of an Event Study............................................................................54
3.3 Estimation of Abnormal Returns..................................................................56
3.3.1 Overview..................................................................................................56
3.3.2 Market Model Approach..........................................................................56
3.3.3 Market Adjusted Return Model Approach...............................................57
3.3.4 Time-Series and Cross-Sectional Aggregation.........................................58
3.4 Estimation of Abnormal Short Selling Activity...........................................59
3.4.1 Overview..................................................................................................59
3.4.2 Mean Adjusted Approach.........................................................................60
3.4.3 Market Model Approach..........................................................................61
3.4.4 Time-Series and Cross-Sectional Aggregation.........................................62
3.5 Hypotheses Testing......................................................................................63
3.5.1 Tests of Equality......................................................................................64
3.5.2 Single Hypotheses Tests..........................................................................65
3.6 Summary......................................................................................................66
4 Data, Full Sample and Variable Construction...............................................67
4.1 Data Sources.................................................................................................67
4.1.1 Daily Short Sale Transaction Data...........................................................67
4.1.2 Convertible Bond Data.............................................................................69
4.1.3 Stock, Firm, and Accounting Data...........................................................69
4.2 Full Sample Construction.............................................................................70
4.3 Variable Construction..................................................................................71
4.3.1 Firm and Stock Characteristics.................................................................71
4.3.2 Trading Activity Variables.......................................................................73
4.3.3 Dummy Variables....................................................................................74
4.3.4 Convertible Bond Variables.....................................................................75
4.4 Summary......................................................................................................76