When we are trying to determine the risk characteristics of a convertible bond (busted convertible, stock, hybrid), do we compare the stock price against the conversion price of the bond (par/conversion ratio) or against the market conversion price (convertible bond price(t+1)/conversion ratio)?
Curriculum (reading 37, BlueBox 9, exercise 7) and Topic Test FI - BUSAN (question 2) are approaching this question in different ways.
Thanks!
You’d want to look at the conversion price versus the stock’s current market price. The minimum value of a convertible bond is the max of a straight bond (in instances where the option holds no value and the conversion price is well above the current market price) or the conversion value (in instances where the option holds a lot of value as the conversion price is well below the current market price).
If the conversion price is $20 and the current stock price is $40, the convertible bond’s risk characteristics will look very similar to the underlying stock.
If the conversion price is $20 and the current stock price is $5, the convertible bond’s risk characteristics will look very similar to the straight bond.
Hope that answers your question!
Thanks! When you refer to the conversion price, is it the conversion price at inception (par/conversion ratio) or the current (market) conversion price (current price of bond/conversion ratio).
It’d be the conversion price at inception, which is in effect the “strike price” of the embedded call option on the stock. The current market price of the embedded option in the convertible bond will fluctuate depending on the underlying share price.
Blackmamba
you said if the stock price is 40 at conversion price is 20 it would behave like a stock.
are you sure about this? I thought it would be busted and behave like a bond because you wouldn’t convert something worth 40 to 20.
can you confirm?
I think you have it backwards: you’re converting something that based on the conversion ratio and par of the bond is costing you $20 into a market price of $40.
If the initial conversion price is $20 (e.g., you bought a $1000 bond at par that can be converted into 50 shares), and the shares are currently trading for $40, it means your 50 shares that could be converted at an effective price of $20/share are worth $2000 (i.e., your conversion value, calculated as $40/market price per share * 50 shares per bond held). The minimum value of this convertible bond has to be the max of the straight-bond or its conversion value.
When the stock’s price is high relative to the conversion price, the conversion value will exceed the straight-bond, and the conversion value is driven by the price of the stock.
Rex, check out exhibit 30 towards the end of reading 37 in Fixed Income, that should help.
Maybe someone else can chime in if I’m missing something?
My apologies Mamba, you are indeed correct. Got a little confused there.
So if the Convertible price is 40 and the share price is 50, this would behave like a stock. Upon reflection it makes sense: I think of this has the option having value, as you have the right to convert it at 40 and sell it at 50 in the spot market to lock in profit. Is that correct?
Yea, that’s a good way to think about it. Holding all else constant, a rising stock price means the option is increasing in value, with the value of the convertible bond being = straight bond + value of embedded call option on the stock. The higher the stock price relative to the conversion price, the more the convertible bond’s price behaves like the underlying stock.
Check out that exhibit in R37 and it’ll nail it all home I think!