Question:

On August 20, 2004, Countrywide Financial Corporation (CFC) offered a new convertible security
due in 2031 (the “new securities”) in exchange for an equal amount of its liquid yield option notes
(LYONs, the “old securities”). For each $1,000 of principal amount at maturity of the old securities,
the company was offering to exchange $1,000 of principal at maturity of the new securities and a
cash payment of $2.50. Both new and old securities are puttable and callable. The exchange offer
expired at midnight on September 17. Most investors chose to convert.
For each $1,000 of principal amount of the new securities, it could convert to a number of shares
of common stock, which equals to the conversion rate (46.2820) multiplied by the average stock
price in the last 20-day stock price, minus the principal, all divided by the average stock price in
the last 20-day stock price. That is to say, if you sell the share right after you convert, then the
equivalent conversion proceeds is 1000+P*(46.2820*A-1000)/A, where P is the current share
price and A is the last 20-day average stock price.
On October 20, suppose you were one analyst on trading floor in one hedge fund covering the CFC
securities at that time. On that day the company announced earnings per share (EPS) of $0.94 for
the third quarter, which fell short of the analyst consensus estimate of $1.01. Before announcement,
the average price of the CFC is $37. On the announcement day, the stock price had dropped 11.5
percent to $33.17. You noticed that the trading volume of convertible bond shot up and was
abnormally high.
1. Is the conversion option relevant?
2. Is there an arbitrage opportunity on October 20? If there is, please describe your strategy.
3. What’s the cost and benefit to the investors and the company, respectively?
4. Now suppose you can foresee the future (That is to say, google what happened to the
CFC afterwards). Is the arbitrage strategy your optimal trading strategy?
Countrywide Financial Corporation Daily Closing Prices of the Stock and the New Convertible Securities

Price of the New

Conversion Rate
Convertible Security per Stock Price
Date (46.2820)*(2)
$100 par
(1) (2) (3)
9/23/2004 - 36.89 1559.783
9/24/2004 - 37.78 1597.414
9/27/2004 179.125 38.20 1767.97
9/28/2004 179.750 38.34 1774.45
9/29/2004 180.250 38.56 1784.63
9/30/2004 184.125 39.39 1823.05
10/1/2004 183.875 39.34 1820.73
10/4/2004 183.250 39.21 1814.72
10/5/2004 183.125 39.17 1812.87
10/6/2004 181.375 38.80 1795.74
10/7/2004 182.750 39.10 1809.63
10/8/2004 179.125 38.30 1772.60
10/11/2004 179.500 38.39 1776.77
10/12/2004 181.750 38.89 1799.91
10/13/2004 180.875 38.68 1790.19
10/14/2004 179.125 38.30 1772.60
10/15/2004 178.375 38.14 1765.20
10/18/2004 181.125 38.75 1793.43
10/19/2004 175.375 37.50 1735.58
10/20/2004 156.750 33.17 1535.17
10/21/2004 152.750 31.89 1475.93
10/22/2004 158.250 31.90 1476.40
Source: Bloomberg and CRSP.