Earnings Management and Convertible Bond Arbitrage

We bring together two streams of research: one on earnings management and the other on convertible bond arbitrage. In doing so, we bring new insights on why convertible bond hedge funds benefit from convertible bond arbitrage. Specifically, we find that firms managing their earnings prior to their convertible bond issuance have: (1) poorer stock market and earnings performance after their issuance of convertible debt, (2) higher idiosyncratic volatility prior to issuance, (3) more equity like convertible bonds, and (4) an abnormal increase in the short selling of their stocks after issuance of convertible bond. Consequently, we provide evidence consistent with the notion that earnings management prior to the issuance of convertible bonds is a source of profits for convertible bond hedge funds that pursue convertible bond arbitrage.