Assume that you are planning to do a convertible arbitrage trade. Convertible bond characteristics: Annual pay bond: Maturity: 5 years, Par value: $1000, Coupon Rate 10%, Price $950

Non-convertible bonds (AKA "straight bonds") are trading for $837.21, implying a YTM of 13% for these bonds.

Conversion Ratio: 40 (each individual bond is convertible into 40 shares of stock)

Conversion price: Par/conversion ratio: $25/share

Current stock price: $22/share

Stock annual dividend: $2/share

Conversion value: Market price of stock x conversion ratio: $22 x 40 = $880

Bond delta: 0.90

1a. How many shares of stock do you need to short for each bond in order to be properly delta-hedged?

1b. What is the trade that you will make? Be specific as to which asset you are buying and what it costs/generates and which you are short-selling and what it costs/generates and what the net cash flow is.

1c. Calculate the net cash flows and market value gains and losses at the end of one year assuming that the stock price goes down by 20%. Assume that the YTM on the straight bond is 18%. Ignore any interest on short proceeds to make the problem easier. Be sure to consider all other appropriate cash flows and changes in value that happened over this epriod.

1d. What is your return on investment?

1e. What would your return on investment had been in you had simply purchased the convertible bond and held it for one year? (Hint: redo #d & #e above without the position in the stock, you don't need to rewrite everything)