LA 5: R&B Online Ch IV: Convertibles

Question 1

What is a convertible security?

Answer 1

Security that gives owner
RIGHT (not obligation)
to CONVERT the EXISTING investment into ANOTHER FORM

Question 2

What type of security are convertible securities normally? What can these securities be exchanged for?

Answer 2

BOND or PREFERRED STOCK exchanged for COMMON STOCK according to a predetermined formula

Question 3

What does a convertible security exist of?

Answer 3

It is a hybrid security consisting of:

• bond or preferred stock holding
• call option that allows for conversion

Question 4

What is the conversion ratio of a convertible bond?

Answer 4

shares obtained if converted

Question 5

How is the conversion price of a convertible bond calculated?

Answer 5

Face value / Conversion ratio

Question 6

What is the conversion value of a convertible bond?

Answer 6

The market value of the stock into which the convertible bond can be exchanged

Question 7

What is the conversion parity price of a convertible bond?

What happens at this price.

Answer 7

The STOCK PRICE that makes the CONVERSION VALUE EQUAL to BOND PRICE
This is the price where immediate conversion of the bond into the stocks makes sense

Question 8

How is a convertible bond’s minimum value calculated?

Answer 8

Step 1: Calculate the value of the bond as a straight bond (I.e. the bond’s value if he had no conversion feature
Step 2: The value of the common stock to be received upon the conversion

Question 9

What is a convertible bond’s payback?

Answer 9

Break-even time; how long the higher interest income (of the bond) must persist to make up for the difference between the price of the bond and its conversion value (i.e. the conversion premium)

Question 10

How is a convertible bond’s payback calculated?

Answer 10

Payback = (conversion price - conversion value) / (bond income - income from equal investment in common stock)

Question 11

How is the value of a non-callable convertible calculated?

Answer 11

= value of straight bond + call option on amount of common shares equal to conversion ratio

Question 12

How is the value of a callable convertible calculated?

Answer 12

= value of straight bond + call option on amount of common shares equal to conversion ratio - value of call option on bond

Question 13

Explain the situation known as ‘forcing conversion’.

Answer 13

A bond trading well above par will be called by the ISSUER at PAR.
Investors will CONVERT as a result because
STOCK worth more than CALL PRICE they would receive

Question 14

What is the effect on the value of the convertible if the volatility of the underlying stock increases?

Answer 14

The value of the bond increases since the value of the conversion option increases

The value of the convertible bond = 
value of straight bond
\+
value of conversion option
-
value of call option on the bond

Question 15

What is effect on the value of a convertible bond if the interest rate becomes more volatile?

Answer 15

The value of the convertible decreases since:
- chance of bond being called increases
CAUSING
- the value of the call option on the bond to increase

The value of the convertible bond = 
value of straight bond
\+
value of conversion option
-
value of call option on the bond

Question 16

What is the convertible bond’s minimum price?

Answer 16

Max{conversion value;straight bond price}

Question 17

How do you calculate the net value of the convertible options and call option?

Answer 17

Convertible market price - straight bond value