Capital structure arbitrage: common and preferred stock
Posted: August 18th, 2011, 6:09 pm
Hi,I'm in the process of writing my Bachelor's thesis, and I would like some feedback on the following idea:Constructing a pairs trade with the common and preferred stock of the same company. For pretty much every company I've looked at so far, the price movements of the common and preferred stock follow each other tightly, and the price ratio between the two stocks, for most companies, is pretty much the same over time (with volatility around this mean varying a lot between different companies).How realistic is it to be able to construct such a trade? Here are some things that I worry about:1. Shorting not allowed, even in normal times (my data goes back to the years 1990 or 2000 in most cases). Is shorting preferred shares allowed on most exchanges?2. Liquidity. From what I've seen so far, the liquidity is quite low in preferred shares, especially so farther back in time. Perhaps I can assume this away? It is a Bachelor's thesis after all.3. Idiosyncrasies of preferred stock. Depending on the exchange and the specific company, the preferred stock may give the owner certain rights, such as the right to convert to ordinary stock, which I am clueless about how to handle when testing a strategy. 4. What else do I need to take into account, or assume away? Transaction costs, ability to buy/sell continuous amounts (so that every trade is self-financed)5. Anything else that I am missing? Anything that means that I should scrap the whole idea?Some practical issues:Adjusted prices for the data?How to handle missing price data? For some of the preferred shares, prices are missing from some dates. Do I replace missing prices with the last observed price?All help appreciated. I hope I've placed this thread in the right place. EDIT: I can't assume those things away - that would make it ridiculous. Perhaps it's still a topic worth discussing though.