Arbitrageurs are typically seen to fulfill the role of price correction by exploiting the gap between over- and under-pricing. But new research suggests they have an additional, important role: as suppliers of investment capital to firms.

Darwin Choi of HKUST and his co-authors Mila Getmansky, Brian Henderson and Heather Tookes focus on convertible bonds, which are an important source of financing for a wide variety of firms, particularly distressed firms with depressed equity prices. While previous research has focused on the demand-side determinants in convertible bond issuances, the authors focus on the supply side - that provided by arbitrageurs.

"The convertible market has, at times, been comparable in size to the market for new equity issues. Convertible bond arbitrage hedge funds are widely believed to purchase more than 75 per cent of primary issues of convertible debt," they say.

These hedge funds make a good basis for studying the supply impacts on issuance because it is possible to isolate from them important measures of capital supply. In particular, the authors focus on convertible arbitrage hedge fund flows, fund returns, and the degree of leverage used by the arbitrageurs. The effects of these are investigated using U.S. data from 1995-2008.

"Given arbitrageurs are primary market purchasers and convertible bonds tend to be under-priced relative to fundamental value at issue, positive shocks to the capital positions of these arbitrageurs might result in upward bond price pressure, making issuance more attractive to firms," they say.

Their results show a positive effect for all three measures of capital supply. All else equal, a one-standard deviation increase in hedge fund flows leads to a 38.6 per cent increase in the supply of funds to issuers of convertible bonds.

Further support for this is found by looking at the fallout from an external event - the short-selling ban implemented by the U.S. Securities and Exchange Commission over three weeks in September-October 2008.

In the convertible bond market, arbitrageurs typically buy undervalued bonds and hedge equity price risk by taking short positions in the equity. "The ability to sell short the equity of convertible bond issuers is critical to convertible bond arbitrage activity. If supply of capital matters to issuance, we should see a drop in issuance during the time of the short-selling ban," the authors say.

And this is precisely what they saw. Average weekly proceeds from convertible bond issues fell from $944 million in the first half of 2008 to $20 million during the ban. The average number of issues dropped from nearly three a week during January-July 2008 to just one issue during the entire three-week ban.

"The ban on short-selling resulted in an unfavorable shift in supply conditions and a decline in issuance," they say.

This upheld their original point: arbitrageurs' ability to supply convertible bond capital is an important driver of issuance.