Watch the Premium Expand: Bond Holds Up, Stock Collapses

From an arbitrageur’s perspective, this was a grand slam. Let’s say you set up the trade in the fall of 2000, buying the bonds at 160 while shorting all the underlying shares at 480. On a $1 million face amount trade, this would have involved paying $1.6 million while selling short stock worth 3.05×480 or $1,464,000, or a net payment of $136,000. You might already recognize this payment as the conversion premium—if not, don’t worry. We’ll cover it more thoroughly later.

If you walked away from the trade to revisit in March of 2001, here’s what you would have found. The stock you’d shorted was now worth 3.05×107.25 or just over $327,000, while the bonds you’d bought were down to $775,000. The difference between what you owned and what you owed, originally $136,000, was now almost $450,000! Even without using borrowed money, this represented far more than a tripling of your capital. The best part was that had the stock made a big move in the other direction, your loss would have been trivial compared with this gain, because the convertible would have closely tracked the stock on the upside.