On August 20, 2004, Countrywide Financial Corporation (CFC) offered a new convertible security due in 2031 (the new securities') in exchange for an equal amount of its liquid yield option notes (LYONs, the "old securities'). For each $1,000 of principal amount at maturity of the old securities, the company was offering to exchange $1,000 of principal at maturity of the new securities and a cash payment of $2.50. Both new and old securities are puttable and callable. The exchange offer expired at midnight on September 17. Most investors chose to convert. For each $1,000 of principal amount of the new securities, it could convert to a number of shares of common stock, which equals to the conversion rate (46.2820) multiplied by the average stock price in the last 20-day stock price, minus the principal, all divided by the average stock price in the last 20-day stock price. That is to say, if you sell the share right after you convert, then the equivalent conversion proceeds is 1000+P*(46.2820*A-1000/A, where P is the current share price and A is the last 20-day average stock price. On October 20, suppose you were one analyst on trading floor in one hedge fund covering the CFC securities at that time. On that day the company announced earnings per share (EPS) of $0.94 for the third quarter, which fell short of the analyst consensus estimate of $1.01. Before announcement, the average price of the CFC is $37. On the announcement day, the stock price had dropped 11.5 percent to $33.17. You noticed that the trading volume of convertible bond shot up and was abnormally high. 1. Is the conversion option relevant? 2. Is there an arbitrage opportunity on October 20? If there is, please describe your strategy. 3. What's the cost and benefit to the investors and the company, respectively? 4. Now suppose you can foresee the future (That is to say, google what happened to the CFC afterwards). Is the arbitrage strategy your optimal trading strategy? Countrywide Financial Corporation Daily Closing Prices of the Stock and the New Convertible Securities Price of the New Convertible Security per $100 par Stock Price Conversion Rate (46.2820*(2) Date (1) (2 9/23/2004 9/24/2004 9/27/2004 9/28/2004 9/29/2004 9/30/2004 10/1/2004 10/4/2004 10/5/2004 10/6/2004 10/7/2004 10/8/2004 10/11/2004 10/12/2004 10/13/2004 10/14/2004 10/15/2004 10/18/2004 10/19/2004 10/20/2004 10/21/2004 10/22/2004 179.125 179.750 180.250 184.125 183.875 183.250 183.125 181.375 182.750 179.125 179.500 181.750 180.875 179.125 178.375 181.125 175.375 156.750 152.750 158.250 36.89 37.78 38.20 38.34 38.56 39.39 39.34 39.21 39.17 38.80 39.10 38.30 38.39 38.89 38.68 38.30 38.14 38.75 37.50 33.17 31.89 31.90 (3) 1559.783 1597.414 1767.97 1774.45 1784.63 1823.05 1820.73 1814.72 1812.87 1795.74 1809.63 1772.60 1776.77 1799.91 1790.19 1772.60 1765.20 1793.43 1735.58 1535.17 1475.93 1476.40 Source: Bloomberg and CRSP On August 20, 2004, Countrywide Financial Corporation (CFC) offered a new convertible security due in 2031 (the new securities') in exchange for an equal amount of its liquid yield option notes (LYONs, the "old securities'). For each $1,000 of principal amount at maturity of the old securities, the company was offering to exchange $1,000 of principal at maturity of the new securities and a cash payment of $2.50. Both new and old securities are puttable and callable. The exchange offer expired at midnight on September 17. Most investors chose to convert. For each $1,000 of principal amount of the new securities, it could convert to a number of shares of common stock, which equals to the conversion rate (46.2820) multiplied by the average stock price in the last 20-day stock price, minus the principal, all divided by the average stock price in the last 20-day stock price. That is to say, if you sell the share right after you convert, then the equivalent conversion proceeds is 1000+P*(46.2820*A-1000/A, where P is the current share price and A is the last 20-day average stock price. On October 20, suppose you were one analyst on trading floor in one hedge fund covering the CFC securities at that time. On that day the company announced earnings per share (EPS) of $0.94 for the third quarter, which fell short of the analyst consensus estimate of $1.01. Before announcement, the average price of the CFC is $37. On the announcement day, the stock price had dropped 11.5 percent to $33.17. You noticed that the trading volume of convertible bond shot up and was abnormally high. 1. Is the conversion option relevant? 2. Is there an arbitrage opportunity on October 20? If there is, please describe your strategy. 3. What's the cost and benefit to the investors and the company, respectively? 4. Now suppose you can foresee the future (That is to say, google what happened to the CFC afterwards). Is the arbitrage strategy your optimal trading strategy? Countrywide Financial Corporation Daily Closing Prices of the Stock and the New Convertible Securities Price of the New Convertible Security per $100 par Stock Price Conversion Rate (46.2820*(2) Date (1) (2 9/23/2004 9/24/2004 9/27/2004 9/28/2004 9/29/2004 9/30/2004 10/1/2004 10/4/2004 10/5/2004 10/6/2004 10/7/2004 10/8/2004 10/11/2004 10/12/2004 10/13/2004 10/14/2004 10/15/2004 10/18/2004 10/19/2004 10/20/2004 10/21/2004 10/22/2004 179.125 179.750 180.250 184.125 183.875 183.250 183.125 181.375 182.750 179.125 179.500 181.750 180.875 179.125 178.375 181.125 175.375 156.750 152.750 158.250 36.89 37.78 38.20 38.34 38.56 39.39 39.34 39.21 39.17 38.80 39.10 38.30 38.39 38.89 38.68 38.30 38.14 38.75 37.50 33.17 31.89 31.90 (3) 1559.783 1597.414 1767.97 1774.45 1784.63 1823.05 1820.73 1814.72 1812.87 1795.74 1809.63 1772.60 1776.77 1799.91 1790.19 1772.60 1765.20 1793.43 1735.58 1535.17 1475.93 1476.40 Source: Bloomberg and CRSP