Book says it’s max (straight value, conversion value) because of arbitrage opportunities: a smaller conversion value will mean that it would be purchased and immediately converted and sold for more. Does this also mean that the reverse is true–if conversion is higher then the bond could be sold then bought for a profit? Does this mean that straight value should theoretically equal conversion value?
i doubt they can have the same value. this is because then the convertible buyer has no large incentive to buy the convertible to begin with then.
Arbitrage only works one way: If the bond sells for less than its conversion value, then you purchase it, convert it, and sell the stock for the higher price. The other way around it doesn’t work - you can’t buy stock and convert it to a bond. That means there is no mechanism that will make the straight value equal to the conversion value. They can be different. The mechanisms at work here are 1) The arbitrage described above. This will drive the bond’s price to the conversion value. 2) If the bond sells for less than its straight value, then it’s just a cheap bond. And intelligent people will buy it and drive the price to the straight value, which is just the present value of the future cash flows. So you have these two mechanisms at work that ensure that the bond’s price will be the greater of straight and conversion value.
naze duck has invented a new instrument for the markets A convertible stock (to a bond). When things are bad, and AIG default risk is at your door, just convert to a 5%!
There sure was a market for that kind of derivative in the last half year.
If the bond market price is higher why isn’t the minimum value the greater of CV, SV, and market price of this convertible bond?