Hi guys, I’m studying reading 50 at the moment, Valuing Bonds with Embedded Options.
Everything was going smoothly till I reached Convertible Bonds. It says that the owner of a convertible bond has the right to convert the bond into a fixed number of common shares of the the issuer. This is the point I dont get, if the owner of the CB has the right to convert it to shares isnt this technically and embedded put option? It also says that the for a convertible bond the bondholder owns the embedded call option, whereas for a callable bond the issuer owns the call option.
I’m finding this point kind of confusing, it is LOS 50 j. Any help clarifying it would be highly appreciated.
A put option is the right to sell shares of the underlying. You’re putting (selling) the stock to someone else at the strike price as the put holder.
A call is the right to buy shares of the underlying. You’re calling away (buying) the stock from someone else at the strike price as the call holder.
I’m sure this is review for you but think about it that way. The option on a convert then, what happens? Are you selling the stock to someone or calling it away from someone else? If you convert the bond into stock who winds up owning the stock? You do. You’re “buying” or “calling away” the stock by converting the bond.
A callable bond is a different concept but I could see how it’s confusing. Again think about a call. The call holder exercises the call and the call seller then is obligated to sell back the underlying at the strike price. With a callable bond, the bond holder has sold a call option to the bond issuer. This is a complete 180 from a convert bond. Also, here the option is on the bond itself and NOT the common stock or another security. With a convert, the option is on the common stock.
As interest rates go down the price of the bond goes up. Let’s assume the bond issuer issued the bond at 98 and now rates have dropped. The bond now trades at 100. The issuer would then want to buy the bond back so it can reissue debt at a lower interest rate. So, in this case, the bond is called away from you, the owner, (assuming it’s callable at 100) since you’ve sold the call.
Hello, Adam. It helps if you think about it in terms of option payoff. Think about the payoff diagram for a call option. It’s flat until the strike and then goes diagonally upwards. The option on a convertible bond has the same payoff. The conversion option is worthless until the strike price (the price where converting becomes as valuable as the equivalent non-convertible bond). After that, as stock price increases, the option price increases. Just like a normal call option.
I can not thank you guys enough for your extremely informative and helpful replies! I completely understand the concept now This was my first post and I am very glad I found this forum!
This was my first post and I am very glad I found this forum!