In- and out-of-the-money convertible bond calls: Signaling or price pressure?

- We model the market reaction to in- and out-of-the-money convertible bond calls.
- The aim is to identify signaling and price pressure effects.
- In-the-money calls are dominated by price pressure effects.
- Out-of-the-money calls are dominated by signaling effects.
- The announcement effect for out-of-the-money calls is related to size of the call.

Convertible bond calls typically cause significant reactions in equity prices. The empirical research largely finds negative and positive announcement effects for the in-the-money and the out-of-the-money calls respectively. However, this research has difficulty distinguishing between the two main theoretical explanations: the signaling effect and the price pressure effect. In this paper, we differentiate between these two effects by using a unique data set of the in- and the out-of-the-money calls in the United States during the period of 1993 to 2007. We find that the announcement effect for the in-the-money call is predominantly explained by the subsequent order imbalances; and the stock market's reaction is spread over an entire trading day, which is consistent with the price pressure effect. In contrast, the announcement effect for the out-of-the-money call is driven by the size of the called convertible bond; and the stock market's reaction is almost immediate, which is consistent with the signaling effect.