Conversion Arbitrage: Dividend Risk And Reward
By John Summa
Up to this point we have been concerned with a simplified conversion model, where there are no carrying costs, interest earnings on credit balances, dividend payments or payouts to be concerned with as an arbitrageur. Now we will begin to relax some of these assumptions. While not all stocks a conversion arbitrageur is following will pay dividends, those that do can substantially alter the equation. For the conversion arbitrageur this can potentially be a source of additional profit, but with it comes some associated risk. (Find out more about the risk/reward payoff in Naked Options Expose You To Risk.)
When dividends become part of the equation, the dividend payment can be earned by the arbitrageur because he or she is long in the stock. Provided that the ex-dividend date (ex-date) for the stock is between entry date and expiration date of the conversion, it is possible to add to any conversion profit that has been locked in by the amount of the dividend to be paid. Like most things, more profit means more risk and often the option pricing for a conversion contains the expected dividend payment, or part thereof, and there is no guarantee that a dividend is going to be paid. (Find out more in How Dividends Work For Investors.)
Let's not get ahead of ourselves. First, let's add dividend payments into the conversion profit equation so that is clearly understood.
Figure 10 contains the profit calculation for a conversion with dividend payment. As shown, using the April 100 ABC stock conversion (the April options are used here because the expiration date must be later than the ex-dividend date in order to capture the dividend). ABC stock is scheduled to pay a dividend of 40 cents in March 2009. Therefore, the conversion price actual cost is reduced by this amount. Suppose we have a price of $101.08 for the April conversion.
|April 100 Conversion Profit Calculation w/ Dividend and no Carry Costs|
|(Conversion Price - Dividend)||
|$101.08 - $.40 = $99.68|
|Figure 10: Conversion profit assumes no transaction or carrying costs but now includes a dividend payment of $.40 per share on ABC stock. Here April 100 \'09 strikes are used.|
This price is eight cents above the strike price. Therefore, the conversion itself is not profitable because the purchase price $101.08 is greater than the strike price, as we demonstrated in the previous sections on conversion profitability determination. But when we factor in the receipt of a dividend payment of 40 cents, the cost drops to $99.68, leaving room for a profit of 32 cents per share or $32 for each conversion. This looks great provided that the dividend is not canceled or lowered. (Learn more in Is Your Dividend At Risk?)
Leaving aside carrying costs, the conversion could not lose provided that the dividend is not cut by more than $32. Recall that it is possible for a surprise dividend cut to be announced or, on the plus side, a dividend increase, which would add to the potential profitability of the conversion.
Reversals and Dividends
When doing reversals, it should be made clear that the short stock position in the trade means that the strategy carries dividend risk. If you are short stock going into an ex-dividend date, the reversal strategist will need to pay the dividend, not earn it. (Understanding the dates of the dividend payout process can be tricky. We clear up the confusion in Dissecting Declarations, Ex-Dividends And Record Dates.)
Therefore, when pricing reversals it is important to factor that payment into the equation, or to avoid dividend-paying stocks to sideline that risk factor in the pricing. The reversal strategist brings in a credit balance with the sale of the put and stock short sale. Therefore, interest is earned on this balance. We take up this aspect in the following section, along with the interest costs for conversions.
In this part of the conversion tutorial, the simple model of a conversion with no dividends was relaxed. While dividends ultimately lower the cost of the conversion, they carry with them potential risk. For reversals there is dividend liability, but interest earnings on short sale proceeds help offset that cost. Profit that essentially amounts to a dividend capture can be realized with a conversion strategy, although not without certain risks.
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