Negative conversion premium

Abstract

We document frequent occurrences of negative conversion premium (NCP) events in the Chinese convertible bond market, when the bond is convertible and the underlying stock can be freely sold. This implies that when an NCP event occurs, existing stock holders can earn a riskless profit through a long-short strategy which sells the underlying stock and buys the convertible bond at the same time, then converts the bond into stocks. Facing short sale constraints, traders not holding any position in the underlying stock can still profit from an overnight trading strategy which buys the convertible bond at the NCP event day t, then sells the converted stock on day t + 1. We also find that the next-day opening prices following NCP events are significantly lower, which is evidence for the stock selling from the overnight trading strategy. Overall, our findings show that investors in China are aware of the NCP events and they earn abnormal returns through active trading. However, it remains as a puzzle why existing stock holders such as institutional investors do not trade away the negative conversion premium through the riskless long-short strategy.