Question: On August 20, 2004, Countrywide Financial Corporation (CFC) offered 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 the 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 are 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 the 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 the 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 bonds 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. Whats 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 afterward). Is the arbitrage strategy your optimal trading strategy?

Countrywide Financial Corporation Daily Closing Prices of the Stock and the New Convertible Securities Stock Price Conversion Rate (46.2820)*(2) (2) Price of the New Convertible Security per Date $ 100 par. (1) 9/23/2004 9/24/2004 9/27/2004 179.125 9/28/2004 179.750 9/29/2004 180.250 9/30/2004 184.125 10/1/2004 183.875 10/4/2004 183.250 10/5/2004 183.125 10/6/2004 181.375 10/7/2004 182.750 10/8/2004 179.125 10/11/2004 179.500 10/12/2004 181.750 10/13/2004 180.875 10/14/2004 179.125 10/15/2004 178.375 10/18/2004 181.125 10/19/2004 175.375 10/20/2004 156.750 10/21/2004 152.750 10/22/2004 158.250 Source: Bloomberg and CRSP. 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 Countrywide Financial Corporation Daily Closing Prices of the Stock and the New Convertible Securities Stock Price Conversion Rate (46.2820)*(2) (2) Price of the New Convertible Security per Date $ 100 par. (1) 9/23/2004 9/24/2004 9/27/2004 179.125 9/28/2004 179.750 9/29/2004 180.250 9/30/2004 184.125 10/1/2004 183.875 10/4/2004 183.250 10/5/2004 183.125 10/6/2004 181.375 10/7/2004 182.750 10/8/2004 179.125 10/11/2004 179.500 10/12/2004 181.750 10/13/2004 180.875 10/14/2004 179.125 10/15/2004 178.375 10/18/2004 181.125 10/19/2004 175.375 10/20/2004 156.750 10/21/2004 152.750 10/22/2004 158.250 Source: Bloomberg and CRSP. 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