Conversion

Covered call = Long stock + Short call (still have downside risk, upside capped). Conversion = Long stock + Long put + Short call (completely riskless - protected both ways). The put in a conversion removes all stock risk, creating a guaranteed outcome.

Transaction costs! Stamp duty (0.5% in UK), commissions, bid-ask spreads typically exceed the tiny arbitrage profit. Market makers can profit because they're exempt from stamp duty and trade at mid prices. For retail, the 'risk-free profit' becomes a certain loss after costs.

Yes, you own the stock, so you receive dividends. HOWEVER, this is already priced into the conversion fair value. The dividend isn't extra profit - it's expected. The risk is if the dividend is different than expected, or if you're assigned on the short call before ex-date and miss it.

You sell your stock at the strike price, guaranteed. Below strike: Exercise your put to sell at K. Above strike: Your call is assigned, delivering stock at K. Either way, you receive the strike price for your stock.

Yes! Not from market risk (that's eliminated), but from: (1) Transaction costs exceeding theoretical profit, (2) Early assignment causing you to miss dividend, (3) Dividend being different than expected, (4) Execution slippage. The 'risk-free' label assumes perfect execution and known dividends.

r = -ln(Conversion Cost / Strike) / T. For example: Conversion costs 496p, Strike is 500p, 60 days to expiry. r = -ln(0.992) / (60/365) = 0.008 / 0.164 = 4.9% annualized. Compare this to the risk-free rate to assess if the conversion is fairly priced.

Early assignment is most likely when: (1) Call is deep in-the-money, (2) Ex-dividend date is approaching, (3) Time value of the call is less than the dividend. The call holder exercises to capture the dividend. This can destroy your conversion profit if you miss the dividend.

They're mirror images. Conversion: Long Stock + Long Put + Short Call (locks in selling at K). Reversal: Short Stock + Long Call + Short Put (locks in buying at K). If one is overpriced, the other is underpriced. Market makers do whichever is profitable.

Example: Stock at 500p, theoretical profit is 8p. Stamp duty = 500 × 0.5% = 2.5p. Commissions and spreads = 6p. Total costs = 8.5p. Profit = 8p - 8.5p = -0.5p LOSS. The 0.5% stamp duty alone often exceeds the entire theoretical arbitrage profit.

Yes, but it's structured differently. Index options are cash-settled, so there's no 'stock' to hold. You'd use futures + options, or construct the position differently. The arbitrage relationship still exists but implementation differs. Box spreads are more common for index arbitrage.

Conversions can have different accounting treatment than outright stock positions. A hedged position may: (1) Qualify for hedge accounting, (2) Have reduced regulatory capital requirements, (3) Have different P&L recognition timing. Treasury teams consider these implications when deciding between conversions and other strategies.

For hard-to-borrow stocks, the conversion may trade below theoretical fair value. Why? The synthetic short embedded in the conversion (short call + long put) provides short exposure without needing to borrow. This is valuable when borrow costs are high, so people pay up for conversions.

Depends on deal structure. Cash deal: Stock becomes worth deal price, options adjusted. Your conversion now reflects different economics. Stock deal: Complex option adjustments for exchange ratio. In either case, the 'risk-free' nature may become less clear during the transition. You need to re-evaluate the position under new terms.

Under Basel III, hedged positions may receive reduced risk-weighted asset (RWA) treatment. A conversion should theoretically be near-zero RWA as it has no market risk. However, the institution must demonstrate: (1) Perfect hedge relationship, (2) No basis risk, (3) Proper documentation. Early assignment risk may limit the capital benefit.

Dividend swaps allow trading expected vs. actual dividends. If you're uncertain about dividends in a conversion, you could hedge with a dividend swap. Alternatively, mispricing between conversion fair value (using consensus dividend) and dividend swap pricing could create cross-market arbitrage. This is institutional territory.