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A corporation has issued $20,000,000 of 7%, 15 year, $1,000 par, convertible debentures, convertible at a ratio of 32:1. The bond is currently trading at 105, while the company's common stock is at $35. Which statements are TRUE?

Respuesta :

jepessoa

Answer:

C) II and III

  • II For an immediate profit, the common shares should be sold short and the equivalent number of bonds purchased
  • III An arbitrage opportunity exists between the price of the convertible and the price of the common

Explanation:

Currently the stock is trading at $35 and the parity price is $32.81 (= market price of bond / conversion ratio = $1,050 / 32 = $32.81), that means that the stock is trading at a premium to parity THIS IS AN OPPORTUNITY FOR ARBITRAGE.

You can make a profit if you SELL SHORT 32 shares at $35 per share = $1,120 and immediately buy 1 bond at $1,050. Then convert the bond into 32 common shares and you will make a $70 profit (= $1,120 - $1,050).

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