cfa text: the higher the premium over straight value, all other factors constant, the less attractive the convertible bond. why?
The higher the option premium to get into a LONG PUT position, all other factors constant, the less attractive the instrument, as againt shorting the underlier directly. why?
wolwol, recall: premium over straight value = (market price of convertible bond - straight value)/straight value This can be interpreted as an “increase” over the straight value of the bond. We know that from arbitrage principles, a convertible bond must be worth at least the conversion value (market price of stock * conversion ratio) or else an arbitrageur can buy the convertible bond, convert it right away, and sell the stock, risk-free, at a higher price than the cost of the bond. Now suppose that the conversion value for a bond is high relative to the straight value (the value of a bond finding the PV of coupon interest and principal pmt at some yield). If that’s the case, then the bond will sell for the conversion value (as described above), meaning if you purchased the bond, your downside risk would be high --> the bond can fall all the way down to straight value. If the premium over straight value is small --> the price drop to straight value is lower and hence your downside risk is lower.
crystal clear, thanks TheAliMan Wrote: ------------------------------------------------------- > wolwol, recall: > > premium over straight value = (market price of > convertible bond - straight value)/straight value > > This can be interpreted as an “increase” over the > straight value of the bond. > > We know that from arbitrage principles, a > convertible bond must be worth at least the > conversion value (market price of stock * > conversion ratio) or else an arbitrageur can buy > the convertible bond, convert it right away, and > sell the stock, risk-free, at a higher price than > the cost of the bond. > > Now suppose that the conversion value for a bond > is high relative to the straight value (the value > of a bond finding the PV of coupon interest and > principal pmt at some yield). If that’s the case, > then the bond will sell for the conversion value > (as described above), meaning if you purchased the > bond, your downside risk would be high --> the > bond can fall all the way down to straight value. > > If the premium over straight value is small --> > the price drop to straight value is lower and > hence your downside risk is lower.
Example illustrates best: Price CB1 = 1000 Price CB2 = 1200 Straigth value for both CB1 and CB2 = 950. Stock XYZ trading at some price P. Case1: The next day, the stock CRASHES!! CB1 & CB2 = 950 now (your loss with cb1 = 50, and cb2: 250) Case2: The next day, the stock goes up by 100 bucks: (your profit with cb1 = cb2 = 100) so if you were the investor in the convertible bond, WOULD YOU PREFER TO PAY MORE, OR LESS for a downside protection that is going to be same for that bond (ie. straight value). Hint: you more the premium over straight value, the more its gonna cost you to buy the same downside protection, hence less attractive it is.
You started like a week ago, how are you already at this section? 