From the desk of Jeroen Bakker
Benelux Consulting Lead, Pierpoint Financial Consulting
This is the third blog in a series on securities lending trading strategies. The first blog was a general overview – who is trading what kind of transactions. The second blog was a deep-dive on index and convertible arbitrage. In this blog, I will go deeper into another trading strategy: event driven arbitrage, with a separate carve-out for scrip dividend trading.
These transactions are predominantly traded by investment banks, hedge funds or specialised brokers, however as Roy Zimmerhansl wrote in his blog a few weeks ago, corporate action driven arbitrage has a huge impact on asset owners as a whole as it generates revenue and contributes to a higher fund performance if done correctly.
As a side note – scrip dividend arbitrage is different from and is not dividend arbitrage on which the European Banking Authority published a report in May. It is important to understand the difference between the two as scrip dividend arbitrage is a standalone trading strategy unrelated to taxation while dividend arbitrage is dependent on capturing differences in tax treaties.
Event Driven Arbitrage
Event driven trading or arbitrage covers a host of different trading strategies however they all evolve around a corporate event such as a merger, acquisition, earnings call or impending insolvency. Expanded to its widest extent, this can also include trading around rights issues, share buybacks and stock splits.
Merger and Acquisition arbitrage is a trading strategy whereby investors simultaneously purchase and sell stocks in one of two scenarios: either one company making a takeover offer for another or two companies in merger negotiations – with the goal to monetise the premium involved.
Let’s use the stock name examples from one of my previous blogs:
· Hong Kong - €50.00 · Amsterdam - €25.00 · Paris - €20.00 · London - €20.00 In this example, Hong Kong makes a bid for London and is offering 1 share of its stock for every 2 shares of London. On paper, this is a €5.00 premium.
An investor makes the following transactions:
· Purchase of 2 shares London @ €20.00
· [Short] Sale of 1 share Hong Kong @ €50.00
· Borrow of 1 share Hong Kong @1 % borrowing fee
While I will provide examples of different price outcomes below, typically the expected outcome is that in relative terms, the price of the acquiring company is expected to fall while the target company share price is expected to rise. Nevertheless, there are many factors that can influence the eventual outcome, hence the reason for me providing different combinations.
If after one month the take-over is completed, the investment return would look as follows (assuming the share prices of Hong Kong and London have not changed):
The shares of London will get exchanged for shares in Hong Kong and the investor will return 1 share of Hong Kong to the lender.
If on the other hand, the take-over falls through, it most likely will have a negative effect on the share price of both London and Hong Kong. I will show the outcome in both a 10% rise and a 10% fall in share price as the investor needs to reverse the original transactions.
If the correlation between Hong Kong and London is negative you could have the following scenarios as well: Hong Kong +10% / London -10% or Hong Kong -10% / London +10%.
In the examples I have used a static 100 basis point lending fee, however, an engaged lender can capture a higher return. The critical takeaway here is that from a borrower’s perspective it is very important to receive the commitment from the lender that the securities are available and remain available throughout the duration of the trade as borrowers often are prepared to provide a profit split for “termed” supply. This profit split can be 50/50 or 60/40 depending on the risk the borrower is taking. In the above example a 50/50 fee split would mean that the lender would receive 50% of €10.00 instead of €0.04 fee; definitely something to think about, particularly for passive holdings.
Scrip dividend arbitrage
This arbitrage tries to benefit where an issuing company declares a dividend for which investors have a choice of stock or cash.
In my previous blog I explained how the trade works – a short recap:
HSBC Holdings pays $0.10 dividend per share with a reinvestment ratio of 1:77.13 and therefore a reinvestment price of $7.7133. If the HSBC share price is higher than $7.7133 (in this example, $8), you can sell the number of shares equal to the amount of shares you are entitled to in the conversion and net $0.2867 ($8 - /- $7.7133) per 77.13 shares.
This calculation model is based on an election of cash by the lender, however, there are different fees available to lenders depending on their commitment when lending. Securities lending traders differentiate amongst three different types of supply when borrowing securities for scrip dividend.
Guaranteed cash elect stock
When lending this stock, the beneficial owner or agent lender can guarantee to elect cash as reinvestment. As a result, the borrower knows exactly the cash amount the lender expects and can trade in the market with certainty. In return, the fee is often based on a fee split between the lender and the borrower. In the above example, 100,000 shares of HSBC would have generated $371.71 to be split between the lender and the borrower.
Historical cash elect stock
Historical cash elected stock is stock for which the beneficial owner or agent lender can’t guarantee cash election but can, based on historical election decisions, indicate if the election would likely be stock or cash. This is less valuable than guaranteed cash elected stock and given that companies offering stock/cash options are typically ‘general collateral’ stocks, often a fee a little higher than GC is paid as there is a potential upside. For example, a fee of 0.35% for a 3-day trade would generate $23.01 revenue as opposed to $13.15 at a GC rate of 0.20%.
Undecided stock is stock for which the election is unknown, as a result, the borrower is not able to benefit from the election and can only trade the optionality. This supply is the borrower’s least favourite (riskiest) and would likely pay less than GC at around a 0.10% fee. In this case the same 3-day trade would generate $6.57 but bear in mind, that is revenue that would not have been generated at all without the scrip dividend trading opportunity.
The trading strategies explained might not be something you as an investor are involved with on a day-to-day basis. However, it is important that if you are active in securities lending you can increase your lending returns by engaging with your securities lending providers for corporate events.
If you are not sure what this could mean for you, speak to an independent advisor. Book a free consultation with one of the Pierpoint team.