Conv

Convertible
Convertible Instruments
Instruments
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Page 1 of 132
Introductory Comment
► Focus principally on regular convertibles which

permit bond holder to convert investment into
common stock, but also touch upon alternative
structures that either give option to issuer, or that
provide for automatic conversion
► Concentrate on relatively simple structures, and leave

for more advanced module second generation of
convertibles such as zero-coupon and contingent
versions and variety of other tax-driven alternatives
► Chapter 5 discusses accounting for these instruments

and implications of issuing convertible from credit
rating and regulatory perspective

Page 2 of 132
Outline
PART ONE
► Chapter 1: basic features of very simple

convertible; process for valuation; sensitivity to
changes in underlying market factors
► Chapter 2: reasons issuers issue and investors

purchase convertible instruments; risks and
benefits for each

Page 3 of 132
Outline
PART TWO
► Chapter 3: reverse convertibles, exchangeables,

reverse exchangeables; how pricing differs from
regular convertible; why issuers issue and
investors purchase these instruments
► Chapter 4: mandatory convertibles: pricing,

reasons for issuing and purchasing

Page 4 of 132
Outline
PART THREE
► Chapter 5: impact convertibles have on balance

sheet, leverage ratios, earnings-per-share, from
accounting, regulatory and ratings perspective
► Chapter 6: Quiz

Page 5 of 132
Chapter 1
► Basic features of very simple convertible;

process for valuation; sensitivity to changes in
underlying market factors
► Should review Equity-linked note module

Page 6 of 132
Background and market data
► Issuer credit spread over swap curve is 200 bps for all maturities; swap
curve is flat at 5% (annually compounded)
► Issuer’s common stock is trading at $40, pays a dividend yield of 2%, and
its annualized volatility is 30%
► Note carefully it is dividend yield that is 2%, which means $0.8 annually
when the spot price is $40, but $1.0 when the spot price reaches $50, and
so on
► Issuer can issue 5-year straight bond at 7%
► Issuer asks how much smaller the coupon would be if the 5-year bond
also gave the holder the option to convert into common shares in the
future

Page 7 of 132
Convertible bond term sheet
Issuer Company ABC
Face Value $100
Issue price $100

Tenor 5 years
Status Senior unsecured

Coupon 3%, paid annually
Conversion option On the maturity date, the holder of the

bond may elect to receive 2 shares of
common stock instead of the bond’s
face value in cash
Prepayment The bond may not be prepaid at any
time

Page 8 of 132
Convertible bond as tradeoff
► Investor sacrifices coupons of 4% annually but has potential of large and

potentially unlimited gains if ABC common stock rises significantly given
right to convert into common shares
► Increase in stock price > $10 over 5 years would result in investor IRR >
3%, and large enough increase would cause IRR > normal IRR on straight
debt of 7%, potentially by significant margin

Page 9 of 132
Basic Convertible Pricing
Call
Inputs Strike Option
$50 $8.47
Risk-free rate 5.00%
Credit spread 2.00%
Coupon 3.00%
RFR (CC) 4.88%
Spot 40
Vol 30%
Tenor 5.00
Div. yield 2.00%
Value of the "pure" bond $83.60
Total value of convertible $100.55
Page 10 of 132
Breakdown of convertible
► So fair value of convertible > issue price of 100
► Convertibles are priced in primary market in

this way, i.e. with small value inducement
above issue price to entice investor, given
limited universe of buyers for instruments of 3% Bond
this complexity and low liquidity ("pure bond")
PV = $83.60
Convertible
Bond +
PV =
$100.55
2 Calls @ 50
("options")
PV = $8.47 x 2
= $16.94

Page 11 of 132
Pricing adjustment for self-referencing
feature
► In contrast to an exchange-traded or OTC option on Company ABC

shares, call option embedded in convertible is a call on ABC shares
written by ABC itself
► So exercise of call is, almost by definition, dilutive to ABC’s existing

shareholders, since company would be receiving $100 (i.e. through
cancellation of debt instrument which conserves its cash balance), but
issuing shares worth more
► Increase in outstanding shares hurts existing shareholders to greater

degree than benefit of cancellation of original debt
► Need therefore to adjust down fair value of embedded 5-year call to reflect
this dilution effect

Page 12 of 132
Dilution adjustment formula
► Dilution adjustment formula is

C×N
C* =
N +M
Where C* is fair value of embedded call,

C is value of regular call as calculated earlier on our worksheet, i.e. ignoring
dilution question,
N is total outstanding number of ABC common shares prior to conversion, and
M is total number of ABC common shares that will be issued assuming
conversion
► Assume ABC has 100 shares outstanding, apart from the 2 shares
underlying the convertible
8.47 × 100
► This would lead to C* = = $8.30
102
Page 13 of 132
Adjusted breakdown of convertible
3% Bond
("pure bond")
PV = $83.60
Convertible
Bond
PV = $100.20
+
2 Calls @ 50
("options")
PV = $8.30 x 2
= $16.60

Page 14 of 132
Dilution adjustment formula – derivation
► Suppose ABC has N shares outstanding; price per share is S; so aggregate market
value of ABC is N x S. Suppose also that M call options with strike X are written on
ABC stock by 3rd party, and Black-Scholes model reveals these to be worth $C
each
► Existence of these calls does not affect the aggregate market value of Company
ABC, since they involve a contractual agreement between two parties unrelated to
ABC, and since upon the issuance and/or exercise of these calls, the balance
sheet, capital structure, earnings and cash flows of ABC, all remain unchanged
► Now change one fact, so that these M call options with strike X are issued by ABC
Company itself: Upon exercise of these calls, the aggregate market value of ABC
should rise by the amount of cash it receives, which is MX, to a total of NS + MX
► But since ABC would now have N + M outstanding shares, the price of each share
should become (NS + MX)/(N+M)

Page 15 of 132
Dilution adjustment formula – derivation
► Next recall that payoff at expiration of call with strike X is written as

MAX [0, Final stock price − strike]
► So in our particular case payoff at maturity can be written as
Payoff = MAX [0, SF − X]

NSF + MX
= MAX [0, − X]
N+M
N
= MAX [0, (S F − X) × ]
N+M
N
= × Payoff under third party call
N+M
► But probability of expiring in-the-money is same for both calls, since this
probability is not affected by whether call issuer is ABC or third party, so
C×N
C* =
N +M
Page 16 of 132
Other pricing adjustments
► So far we have decomposed “regular” convertible into bond +

equity call option
► We have addressed problem of dilutive impact of conversion

through dilution adjustment formula
► Other difficulties are more complex. These include:
1. Bond may not rank pari-passu with senior unsecured debt;

convertibles are often issued as subordinated instruments, so
their cash flows must be discounted at credit spread
appropriate to level of seniority. If only liquid credit curve is the
senior unsecured curve, some sort of model-based upward
adjustment of spreads is required

Page 17 of 132
2. Determining appropriate stock price volatility for option

pricing model. Most convertibles have maturities between 5
and 20 years, while the implied volatility determined from OTC
or exchange-listed markets is based on far shorter instruments
For some stocks historical prices may be available for several

past decades, but these are by definition backward-looking so
not likely to reflect market and company-specific realities today

Page 18 of 132
3. The option to convert the bond into shares is very rarely a

simple European option. More typically, the right to convert
may arise on designated dates in the future, such as on
coupon payment dates – in which instance we would describe
the option as “Bermudan” style; or it may be exercisable on any
date in the future (hence “American”), sometimes after the
passage of a number of years
In more complex instances, the option is exercisable only upon

the occurrence of designated conditions, which makes it a kind
of knock-in option
Any of these alternatives would introduce additional complexity

into the pricing process and push the discussion well beyond
the scope of this module
Page 19 of 132
4. Care should be taken in the calculation of the implied strike

price of the embedded calls, particularly where the option to
convert is Bermudan- or American-style
For one thing, it is not unusual for the bond contract to specify
that accrued interest is foregone when the holder decides to
exercise the option to convert: any such foregone accrued
interest would need to be modeled as an increase in the strike
price of the embedded call option, and this increase would vary
depending on the date of exercise within an interest period if
such exercise is allowed
By the same token, some exotic convertibles have conversion

prices that reset over time depending on the path of the
common stock and other market factors
Page 20 of 132
5. If conversion option can be exercised prior to maturity, it is

harder to determine bond value at that time, since this would
depend on then interest rates, issuer credit spreads, and
remaining bond tenor. This needs to be modeled with
advanced simulation techniques
6. If bond and underlying shares are denominated in different

currencies, valuation of embedded call becomes more
complicated, as these become “quanto” options whose strike
currency differs from currency of underlying shares; quanto
options are discussed in modules on Exotic Options

Page 21 of 132
7. Convertibles are often subject to option enabling issuer to

prepay prior to maturity. Any prepayment option reduces bond
value for investor; but in specific case of a convertible,
prepayment option also diminishes value of embedded equity
option since exercise by issuer shortens tenor of this equity
option. (Many prepayment options contained in convertibles
are exercisable by issuer only when common stock trades at
defined premium to conversion price, and are designed to
“force” conversion by threatening repayment at par unless
bondholders convert into more valuable common shares)

Page 22 of 132
8. Correlation considerations complicate further our analysis;

substantial increase in equity volatility drives upward value of
equity option, but is often accompanied by increase in issuer’s
credit spread, which offsets the benefit to some degree.
Indeed, convertibles are sometimes marketed on basis that
these two factors naturally offset one another, so present a
hedge of one another from the bondholder’s perspective

Page 23 of 132
Convertible price sensitivities*
Factor Pure Bond Call Option Aggregate

Stock price + NR + +
– NR – –
Stock volatility + NR + +
– NR – –
Dividend yield + NR – –
– NR + +
Credit spread + – NR** –
– + NR** +
Risk-free rate + – + ?
+ – ?
Passage of time + – ?
*/ Useful to review module on Equity-linked note **/ Very minor impact

Page 24 of 132
Impact of dividend yield changes
► Remember first that stock’s forward price diminishes if the dividend

yield increases, and increases if dividend yield diminishes, since
forward price is calculated from the formula
Forward = Spot * (1 + RFR ) t
(1 + Div)t
► Thus increase in dividend yield, since it reduces stock forward
price, reduces value of call option while having no impact on pure
bond – and reduction in dividend yield, since it increases stock
forward price, increases value of call option, while also having no
impact on pure bond

Page 25 of 132
Convertible price sensitivities*
Factor Pure Bond Call Option Aggregate

Stock price + NR + +
– NR – –
Stock volatility + NR + +
– NR – –
Dividend yield + NR – –
– NR + +
Credit spread + – NR** –
– + NR** +
Risk-free rate + – + ?
+ – ?
Passage of time + – ?
*/ Useful to review module on Equity-linked note **/ Very minor impact

Page 26 of 132
Impact of interest rate changes &
passage of time
► Rate increases hurt bond given fixed-rate coupon, and benefit

option since they drive higher forward price of common stock;
effects therefore offset to some degree, and net aggregate impact
cannot be determined a priori for all cases
► As time passes call option generally diminishes in value – “time

decay” – while bond, valued initially at 83.60, gradually pulls
towards par; again it is not possible to determine a priori net
aggregate impact in all cases

Page 27 of 132
Important terminology
Issuer Company ABC

► Conversion price:
nominal price per share Face Value $100
at which conversion
takes place, so $50 in our Issue price $100
example
Tenor 5 years
► Conversion ratio: Status Senior unsecured

number of shares each
convertible bond converts Coupon 3%, paid annually
into, usually expressed
on a per 100 basis, so 2 Conversion On the maturity date, the
in our example option holder of the bond may
elect to receive 2 shares of
common stock instead of
the bond’s face value in
cash
Prepayment The bond may not be
prepaid at any time
Page 28 of 132
Issuer Company ABC

► Parity or conversion
or intrinsic value: Face Value $100
spot price of the
common stock Issue price $100
multiplied by
conversion ratio, i.e. Tenor 5 years
the value of the shares
obtained via Status Senior unsecured
conversion at current
spot price – so $80 in Coupon 3%, paid annually
our example on the
issue date. Note that Conversion option On the maturity date, the
a convertible whose holder of the bond may elect
conversion option can to receive 2 shares of
be exercised common stock instead of the
immediately cannot bond’s face value in cash
trade below intrinsic
value Prepayment The bond may not be prepaid
at any time
Page 29 of 132
► Conversion premium: Issuer Company ABC

excess of market value
Face Value $100
of convertible bond over
parity value, at inception
Issue price $100
or at any time thereafter.
So in earlier example Tenor 5 years
conversion premium at
inception is $20 per Status Senior unsecured
bond of $100 face value,
usually expressed as Coupon 3%, paid annually
25% – being minimum
Conversion On the maturity date, the
percentage increase in
option holder of the bond may elect
stock price until shares to receive 2 shares of
obtained from common stock instead of the
conversion exceed in bond’s face value in cash
value bond’s current Prepayment The bond may not be prepaid
price at any time
Page 30 of 132
► Cash payback period: Issuer Company ABC

number of years it takes
Face Value $100
until conversion premium
on day one is recovered
Issue price $100
through excess of
convertible’s coupon over Tenor 5 years
stock’s dividend yield.
So in earlier example Coupon 3%, paid annually
where a $100 investment
in the convertible earns Conversion On the maturity date, the
annual coupon of $3 option holder of the bond may elect to
versus $2 in dividends receive 2 shares of common
with common stock, and stock instead of the bond’s
given $20 conversion face value in cash
premium, cash payback Prepayment The bond may not be prepaid
period is 20 years at any time
Page 31 of 132
Spot Graph
Call Pure Convertible 2 Shares of

Spot Option Bond (aggregate) Common Stock
$20 $1.07 $83.60 $85.73 $40.00
Low Delta $22 $1.48 $83.60 $86.56 $44.00 "Busted
Calls $24 $1.97 $83.60 $87.54 $48.00 Convertible"
$26 $2.54 $83.60 $88.68 $52.00
$28 $3.18 $83.60 $89.97 $56.00
$30 $3.90 $83.60 $91.41 $60.00
$32 $4.69 $83.60 $92.98 $64.00
$34 $5.54 $83.60 $94.69 $68.00
$36 $6.46 $83.60 $96.53 $72.00
$38 $7.44 $83.60 $98.48 $76.00
$40 $8.47 $83.60 $100.55 $80.00
$42 $9.56 $83.60 $102.72 $84.00
$44 $10.70 $83.60 $104.99 $88.00
$46 $11.88 $83.60 $107.35 $92.00
$48 $13.10 $83.60 $109.80 $96.00
$50 $14.36 $83.60 $112.33 $100.00
$52 $15.67 $83.60 $114.93 $104.00
$54 $17.00 $83.60 $117.60 $108.00
$56 $18.37 $83.60 $120.34 $112.00
$58 $19.77 $83.60 $123.13 $116.00
$60 $21.19 $83.60 $125.98 $120.00
$62 $22.64 $83.60 $128.88 $124.00
$64 $24.11 $83.60 $131.83 $128.00
$66 $25.61 $83.60 $134.82 $132.00
$68 $27.13 $83.60 $137.85 $136.00
$70 $28.66 $83.60 $140.92 $140.00
$72 $30.21 $83.60 $144.03 $144.00
$74 $31.78 $83.60 $147.17 $148.00
$76 $33.37 $83.60 $150.34 $152.00
$78 $34.97 $83.60 $153.54 $156.00
$80 $36.58 $83.60 $156.76 $160.00
$82 $38.21 $83.60 $160.01 $164.00
$84 $39.84 $83.60 $163.28 $168.00
$86 $41.49 $83.60 $166.58 $172.00
$88 $43.15 $83.60 $169.89 $176.00
$90 $44.81 $83.60 $173.22 $180.00
Page 32 of 132
Can convertible ever trade below
intrinsic value?
► Depends on conversion option: if American-style, intrinsic value

cannot exceed price of convertible: otherwise a risk-free arbitrage
would involve purchasing convertible, exercising option
immediately, and selling shares for instantaneous profit
► This would drive upward price of convertible and downward that of

common shares, until opportunity disappeared
► Reason it happens here is that we are not dealing with American

option, but rather with European one that can only be exercised at
expiration in 5 years

Page 33 of 132
Can convertible ever trade below
intrinsic value?
► With call option so DITM at spot price of $90 per share, disadvantage of
owning convertible versus common shares stems from difference in their
current yield: convertible continues generating current yield of 3% on 100,
i.e. of $3 per annum, while common would now pay dividend yield of 2%
but on investment worth $180 – 2 shares worth $90 each – so aggregate
of $3.6 annually. Higher yield makes long stock position more attractive
than convertible, since in other respects positions are economically
identical.
► Argument would break down if we assumed shares pay a constant

dividend of $0.8 annually – i.e. 2% of initial stock price of $40; under such
an assumption bond yield always exceeds shares’, so the bond would
always trade at higher price. But constant 2% dividend yield is what we
assumed, i.e. one that rises in cash flow terms with increases in share
price; at high enough share prices, dividends exceed bond’s coupon

Page 34 of 132
Spot Graph
$180.00
$160.00
$140.00
Pure Bond
$120.00
$100.00 Convertible
(aggregate)
$80.00
2 Shares of
Common Stock
$60.00
$40.00
$20 $30 $40 $50 $60 $70 $80 $90
Spot

Page 35 of 132
Chapter 2
► Describe and analyze reasons issuers issue,

and investors purchase, convertible
instruments
► Risks and benefits for each

Page 36 of 132
Convertibles – advantages for
investors
► Convertible is attractive for investors who are bullish on company’s

stock, but are unwilling to take full risk to principal and purchase
shares outright

Page 37 of 132
Convertible IRR v. Common Stock IRR
Initial Investment 100

Initial share spot price 40
Number of shares purchased 2.5
Tenor of investment in years 5
Coupon on bond in USD 3
Dividend on shares in USD 2

Page 38 of 132
Convertible IRR v. Common Stock IRR
IRR
Final Stock Price Stocks Convertibles

$20 -10.28% 3.00%
$22 -8.71% 3.00%
$24 -7.25% 3.00%
$26 -5.87% 3.00%
$28 -4.57% 3.00%
$30 -3.35% 3.00%
$32 -2.18% 3.00%
$34 -1.06% 3.00%
$36 0.00% 3.00%
$38 1.02% 3.00%
$40 2.00% 3.00%
$42 2.94% 3.00%
$44 3.85% 3.00%
$46 4.73% 3.00%
$48 5.58% 3.00%
$50 6.40% 3.00%
$52 7.20% 3.74%
$54 7.97% 4.46%
$56 8.72% 5.16%
$58 9.45% 5.85%
$60 10.16% 6.51%
$62 10.86% 7.16%
$74 14.69% 10.75%
$76 15.28% 11.30%
$78 15.85% 11.84%
$80 16.42% 12.37%
$82 16.98% 12.90%
$84 17.52% 13.41%
$86 18.06% 13.91%
$88 18.58% 14.41%
$90 19.10% 14.89%
Page 39 of 132
Stocks v. Convertibles IRR
19.50%
14.50%
9.50%
4.50%
-0.50%
$20 $30 $40 $50 $60 $70 $80 $90
Stocks
-5.50% Convertibles
-10.50%

Page 40 of 132
Is common stock always better?
► One view is that since pure equity investment outperforms convertible

under any scenario involving an increase of more than $2 in stock price
over 5 years, convertible cannot be justified as a competitor to outright
shares
► Under this argument an investor who does not consider this scenario likely
should steer away altogether from any securities that have an equity
component.
► All depends on how you can afford to be wrong and tolerate risk of
negative IRR that arises with common shares in significant percentage of
scenarios, but rarely under convertible.
► Giving up fraction of annualized IRR in bullish scenarios, but enjoy

guarantee of minimum 3% return in even bearish scenarios, is entirely
appropriate trade-off for many

Page 41 of 132
“Best of both worlds”
► No instrument in capital markets can “offer the best of both worlds”, other than
in a very twisted sense of this expression
► In any rationally-priced and intelligent marketplace, an instrument can offer a

number of trade-offs that may be especially appealing to certain investors –
but rarely to all
► “Best of both worlds” argument promotes convertibles on basis that in bull

equity market, convertibles outperform issuer’s straight debt, while in bear
market convertibles outperform issuer’s common shares
► It is usually left unstated that in bull market, convertibles underperform

issuer’s common shares, and in bear market, convertibles underperform
issuer’s straight debt
► Always unstated that in a market in which the issuer’s common shares rise
but only slightly, convertibles may end up underperforming both
Page 42 of 132
Diversification benefits
► Next argument for inclusion of convertibles in portfolios is that they

offer diversification benefits as performance does not directly
correlate with either equities or bonds
► Therefore, adding convertible bonds to portfolio reduces aggregate

portfolio volatility without causing significant reduction in yield
► Generally this was true for past 3 decades or so, but with interest
rates falling systematically and stock markets rising, it was
inevitable that convertibles would offer attractive returns. Whether
this is sustainable going forward is uncertain
► Discuss more extensively in modules on portfolio management

Page 43 of 132
Non-financial considerations
► Investor is very bullish on ABC but operates under regulations that

penalize heavily stock investments versus straight or convertible
debt
► Assume debt entails 1% capital requirement, while common

shares require 10%. (Reality is even more hostile to stocks in
most instances)
► Investor expects ABC stock in 5 years to reach $70, so can

achieve IRR of 13.47% with equity, versus 9.60% under
convertible

Page 44 of 132
Non-financial considerations
► But – assuming regulation treats convertible as debt rather than

equity – in terms of return on capital – defined as ratio of
annualized return to capital requirement and ignoring funding
costs, operating costs and taxes, shares produce ROC of 134.7%,
versus 960% for convertible
► Maybe capital regulation itself is to blame, because it does not

differentiate between straight debt and convertible, and because
10 times higher capital requirement for equities is not justified by
actual differences in risk.
► This would be reasonable argument, but regulation often brings

about perverse incentives that cause investors to sacrifice superior
returns to enhance accounting or regulatory metrics

Page 45 of 132
Convertible arbitrage funds
► First show first how to derive from price of convertible bond implied
volatility for underlying stock
► Return to our earlier convertible from Chapter 1, and assume it

now carries 5% coupon, while all other observable inputs remain
the same. We say “observable” to remind you that future volatility,
especially over several-year horizon, cannot be determined for
certain, and involves significant judgment
► Use pricing model from earlier to extract single volatility figure that
would make fair value of instrument equal to issue price, i.e. 100

Page 46 of 132
Deriving Implied Volatility
Call
$50 $8.47
Credit spread 2.00%
Coupon 5.00%
RFR (CC) 4.88%
Spot 40
Vol 30.0%
Tenor 5.00
Div. yield 2.00%
Page 47 of 132
Deriving Implied Volatility
Call
$50 $4.10
Credit spread 2.00%
Coupon 5.00%
RFR (CC) 4.88%
Spot 40
Vol 16.3%
Tenor 5.00
Div. yield 2.00%
Page 48 of 132
Convertible arbitrage funds
► Judgment call: does this level of vol sound right for next 5 years?
► If 16.3% sounds low, convertible is cheap, and if 16.3% sounds high,

convertible is expensive
► Specifics of arbitrage strategy are complex, but its essence is to buy

convertible if implied vol is deemed low, and short convertible if
implied vol is deemed high, while achieving zero delta by going short
or long common shares in amount equal to convertible’s delta
► Subject to some risks not materializing – such as rapid change in

issuer credit spread, significant change in dividend policy, or material
change in tax law, arbitrageur makes money if realized volatility
proves consistent with his expectation and different from level implied
by convertible’s price

Page 49 of 132
Summary of strategy
Position Profitable if
Long convertible, short stock Realized vol > implied vol
Short convertible, long stock Implied vol > realized vol

Page 50 of 132
Convertibles – advantages for
issuers
► Issuer’s interest in convertible spans a wide range of considerations

involving tax/accounting/regulatory/legal – some of which are discussed in
Chapter 5 – in addition to strictly financial ones
► Main financial benefit for issuer is coupon savings versus straight debt,
and preservation of cash – both through lower periodic payments of
interest and likelihood that instrument will redeem via delivery of stock
► Still, cannot say convertible is cheaper than straight debt in all cases:
cash outflows are lower than straight debt in all cases, but conversion
dilutes existing shareholders by the newcomers as share certificates
delivered are worth more than debt being converted
► “Rich-man’s problem”: becomes worse precisely when company is doing

better and better and seeing share price soar – so problem well worth
accepting in exchange for reduced cash outflows

Page 51 of 132
Monetizing equity volatility
► Likely correlation between credit spread and equity volatility inures

to issuer’s advantage
► When credit spreads are high and straight debt expensive, equity
volatility is usually high as well, making embedded equity option
more valuable, and pulling convertible’s coupon further down in
relative terms, and sometimes even in absolute terms

Page 52 of 132
Monetizing equity volatility
► To illustrate, assume a straightforward relationship between credit spreads

and equity vol, specifically
Annualized Vol (in %) = 10 × credit spread (in %)
► So when credit spread is 2%, stock’s vol is 20%, and when credit spread
is 4%, stock’s vol rises to 40%
► Can calculate for each level of ABC’s credit spread – and by extension
equity volatility – coupon convertible needs to offer to trade at par. (Ignore
any incentive needed to entice investors into convertible)

Page 53 of 132
Coupon Determination for Convertible
Call
$50 $11.57
Credit spread 5.00%
Coupon 2.34%
RFR (CC) 4.88%
Spot 40
Vol 40%
Tenor 5.00
Div. yield 2.00%

Page 54 of 132
Coupon Determination for Convertible
Call
$50 $14.52
Credit spread 5.00%
Coupon 2.34%
RFR (CC) 4.88%
Spot 40
Vol 50%
Tenor 5.00
Div. yield 2.00%

Page 55 of 132
Spread v. equity volatility v. coupon
Senior unsecured credit Assumed equity Coupon on

spread (in bps) annualized volatility convertible
100 10% 5.02%
200 20% 4.43%
300 30% 3.76%
400 40% 3.05%
500 50% 2.43%
600 60% 1.64%
700 70% 0.98%

Page 56 of 132
Cautionary remark
► It will not always be true that a wider credit spread entails a lower coupon
on convertible
► What is always true is that if wider credit spread is indeed accompanied

by higher equity volatility, then higher funding cost for issuer will be offset,
to some degree or other, by greater value obtained via the convertible
route by selling calls on his own common shares
► This principle is sometimes summarized by saying that convertible is only

major instrument in capital markets that permits a borrower to “monetize”,
or benefit from, an increase in his risk, actual or perceived

Page 57 of 132
Outline
PART TWO
► Chapter 3: reverse convertibles, exchangeables

and reverse exchangeables
► Chapter 4: mandatory convertibles

Page 58 of 132
Chapter 3
► Reverse convertibles, exchangeables, and

reverse exchangeables
► How pricing differs from regular convertible
► Why issuers issue and investors purchase

these instruments

Page 59 of 132
Reverse convertible
Issuer Company ABC
Face Value $100
Issue price $100

Tenor 5 years

Coupon 10% , paid annually
Conversion option On the maturity date, the issuer may
elect to redeem the bond by delivering
to the holder 3 shares of common
stock instead of the bond’s face value
in cash
Prepayment The bond may not be prepaid at any
time

Page 60 of 132
Breakdown of reverse convertible
► Reverse Convertible Bond =

Straight Bond – Put Option
10% Bond
("pure bond")
PV = $112.30
Reverse
Convertible –
Bond
PV = $100.15 3 Puts @ $33.333
("options")
PV = $4.05 x 3
= $12.15

Page 61 of 132
Reverse Convertible Pricing
Put
$33.33 $4.05
Credit spread 2.00%
Coupon 10.00%
RFR (CC) 4.88%
Spot 40
Vol 30%
Tenor 5.00
Div. yield 2.00%
Total value of reverse convertible $100.15

Page 62 of 132
Reverse Convertible IRR
Coupon on bond in USD 10

Page 63 of 132
Reverse Convertible IRR (cont)
Final Stock Price Reverse Convertible IRR

$20 2.37%
$22 3.68%
$24 4.93%
$26 6.11%
$28 7.23%
$30 8.31%
$32 9.34%
$34 10.00%
$36 10.00%
$38 10.00%
$40 10.00%
$42 10.00%
$44 10.00%
$46 10.00%
$48 10.00%
$50 10.00%
$52 10.00%
$54 10.00%
$56 10.00%
$58 10.00%
$60 10.00%
$62 10.00%
$64 10.00%
$66 10.00%
$80 10.00%
$82 10.00%
$84 10.00%
$86 10.00%
$88 10.00%
$90 10.00%
Page 64 of 132
Reverse Convertible IRR
12.00%
8.00%
4.00%
0.00%
$20.00 $30.00 $40.00 $50.00 $60.00 $70.00 $80.00 $90.00

Page 65 of 132
Issuing a reverse convertible
► Principal attraction is ability to de-leverage by canceling outstanding debt

through delivery of stock certificates instead of cash
► This happens precisely when stock price indicates weakened financial

condition for the borrower, making need to de-leverage even more urgent
► Principal drawback is high coupon borrower must pay in return for

conversion privilege
► Investor is attracted precisely by this high coupon, but runs risk that in
adverse scenario, he will receive at maturity common worth (far) less than
original investment

Page 66 of 132
Issuing and pricing exchangeables
► Identical to convertible counterparts, except that issuer is different

from entity whose common stock underlies embedded option
► Thus Morgan bond which I can convert into Morgan shares is a

“convertible; while Morgan bond which I can convert into shares of
Alcatel is an “exchangeable”
► Bond issued by Greek government, which issuer may redeem by

delivering to investor shares in its national railroad, is a “reverse
exchangeable” rather than a reverse convertible

Page 67 of 132
Exchangeable term sheets
Exchangeable Reverse Exchangeable

Issuer Company ABC Company ABC
Face Value $100 $100
Issue price $100 $100
Tenor 5 years 5 years
Status Senior unsecured Senior unsecured
Coupon 3%, paid annually 10%, paid annually
Conversion option On the maturity date, the holder On the maturity date, the issuer
of the bond may elect to receive may elect to redeem the bond
2 shares of common stock of by delivering to the holder 3
Company XYZ instead of the shares of common stock of the
bond’s face value in cash Company XYZ instead of the
bond’s face value in cash
Prepayment The bond may not be prepaid at The bond may not be prepaid at
any time any time

Page 68 of 132
Pricing exchangeables
► Pricing exchangeable or reverse exchangeable works exactly the

same as before; indeed it is easier since some complexities of
convertibles, including need to adjust for dilution from conversion,
do not arise

Page 69 of 132
Chapter 4
► Mandatory convertibles; pricing
► Why issuers issue and investors purchase

these instruments

Page 70 of 132
Mandatory convertible
term sheet
Issuer Company ABC

Par value $1,000
Issue price $1,000
Tenor 5 years
Status Preferred stock
Dividend 7.75%, paid annually
Conversion On the maturity date, each unit of preferred stock with par value $1,000
will convert into common shares of company ABC as set forth below:
(i) If ABC common shares are trading at or below $48 per share,
25 common shares; and
(ii) If ABC common shares are trading above $48 per share, such
number of common shares whose aggregate value at that time
equals $1,200
Prepayment The preferred stock may not be prepaid at any time
► Assignment: Identify 3 differences from previous instruments

Page 71 of 132
Difference: preferred status
Issuer Company ABC

Face Value $1,000
Issue price $1,000
Tenor 5 years
(i) If ABC common shares are trading at or below $48 per share, 25
common shares; and
number of common shares whose aggregate value at that time equals
$1,200
1. Instrument begins life as preferred stock, not debt. Upon conversion it

changes from one type of equity to another.It does not pay a coupon prior
to conversion but a dividend, which is more discretionary

Page 72 of 132
Difference: automatic conversion
Issuer Company ABC

Face Value $1,000
Issue price $1,000
Tenor 5 years
common shares; and
$1,200
2. Conversion is automatic; in five years exactly, holders of preferred tender

their shares and receive common, whether price has risen, fallen or
remained same. Neither party can walk away from conversion feature –
hence name “mandatory”. Note however that this is only one version of
large universe “mandatory” convertibles: specifics differ from case to
case, but all share certainty that conversion will occur in the future
Page 73 of 132
Difference: number of shares delivered upon
conversion is variable
Issuer Company ABC

Face Value $1,000
Issue price $1,000
Tenor 5 years
common shares; and
$1,200
3. Number of shares delivered upon conversion is not fixed in advance, but

depends on spot price of common at maturity. If price is ≤ 48, exactly 25
shares are delivered, but if price > 48, then dollar value of shares
delivered is fixed at $1,200
Page 74 of 132
Deconstructing mandatories
► Decomposing mandatory is not as easy as before, so work

backward and begin by plotting table and graph for IRR under
various price scenarios so as to identify from the graph’s shape
what lies behind

Page 75 of 132
IRR for Mandatory Convertible
Tenor of investment in yea 5
Dividend on preferred shar 77.50

Page 76 of 132
IRR for Mandatory Convertible (cont)
Mandatory Convertible
Final Stock Price IRR
$20 -2.83%
$22 -1.53%
$24 -0.30%
$26 0.87%
$28 1.98%
$30 3.05%
$32 4.06%
$34 5.04%
$36 5.98%
$38 6.88%
$40 7.75%
$42 8.59%
$44 9.41%
$46 10.20%
$48 10.96%
$50 10.96%
$52 10.96%
$54 10.96%
$56 10.96%
$58 10.96%
$60 10.96%
$78 10.96%
$80 10.96%
$82 10.96%
$84 10.96%
$86 10.96%
$88 10.96%
$90 10.96%
Page 77 of 132
Mandatory Convertible IRR
12.00%
8.00%
4.00%
0.00%
$20 $30 $40 $50 $60 $70 $80 $90
-4.00%

Page 78 of 132
► Similarity of graph for mandatory to that for reverse convertible is

misleading: it suggests investor is short put on ABC common; but
due to put-call parity principle it is more user-friendly to visualize
instrument as covered call – i.e. purchase by investor of ABC
common, and simultaneous sale, back to ABC, of call against the
shares purchased.
► Sale of call caps investor’s final payoff and hence IRR; sale of call
earns premium from ABC, which is not paid upfront but as annual
cash flow during 5-year period prior to conversion as part of 7.75%
dividend.

Page 79 of 132
► Size of this cash flow is 5.75% per annum for 5 years, i.e.
difference between 7.75% dividend investor received under the
preferred prior to conversion, and the 2% dividend he would
receive during those 5 years if he purchased common with his
$1,000 instead.
► Specifically investor is purchasing 25 shares of common upfront, at

$40 per share, selling 5-year European call struck at $48 on those
shares, and amortizing premium earned from sale of call over first
5 years as additional $57.50 of dividends.
► Ignore remaining puzzle why, if investor has sold call on all 25

shares and call expires in-the-money, he is left with any common
shares at all after 5 years; focus solely on economics of situation
instead
Page 80 of 132
5-year European call on 25 shares X = $48
$1,000
$20 $20 $20 $20 $20
ABC Investor
+25 shares
Yr1 Yr2 Yr3 Yr4 Yr5
$57.50 $57.50 $57.50 $57.50 $57.50
Yr1 Yr Yr3 Yr4 Yr5

Page 81 of 132
Conversion option
► If ABC common is still < $48, call expires worthless and investor
keeps 25 shares, consistent with term sheet
► If ABC common > $48, call is exercised: normally this would mean
investor transfers shares and receives $1,200 in cash
► Now just replace the cash owed to the investor with ABC shares,
and you get to exactly what the term sheet says – we call this net
share settlement
► Effect of this clause is unmistakable: leaves investor holding not

cash but variable number of shares, and specifically that number
whose aggregate value at that spot price is $1,200 exactly.

Page 82 of 132
Inaccuracies of deconstruction
► First, investor who buys common and sells calls against them
benefits from increases in dividend over 5 years prior to call’s
expiration, while under our mandatory dividend rate is fixed for all 5
years
► Impact of this difference is small, however: $2 initial dividend

growing at 7% p.a. reaches $2.72 by year 5, and PV of these 5
years of growing dividends is around $1.25 higher than that of
constant $2 dividend for 5 years
► So this inaccuracy grosses up to 1% upfront under our stated

assumptions

Page 83 of 132
► Second and conversely, dividend rate on preferred, while not

guaranteed to be paid under all circumstances, is less likely to be
reduced in difficult times than under common
► Exact rights to reduce or suspend dividends under different forms

of preferred vary, but are typically more restricted than under
common, where right is entirely discretionary

Page 84 of 132
► Third, preferred is senior to common under corporate and

bankruptcy law, so holders achieve higher recovery value in
bankruptcy or liquidation

Page 85 of 132
Mandatory Convertible Pricing
Call
$48 $9.00
Senior credit spread 2.00%
Pref-senior credit spread differential 1.75%
Dividend on preferred 7.75%
RFR (CC) 4.88%
Spot 40
Vol 30%
Tenor 5.00
Div. yield on common 2.00%
PV of 5.75% additional dividend annuity $225.11
Total value of calls @ $48 on 25 shares $225.02
Page 86 of 132
Mandatories: benefits and risks
► Significant number of accounting, regulatory and ratings benefits

are discussed later and in more advanced modules
► Financial perspective similar as covered call: investor is

reasonably bullish on ABC common but not too much. Under
mandatory he keeps first 20% of price gains over next 5 years –
i.e. from $40 to $48 in spot – but gives up anything above
► He also supplements dividend from 2% to 7.75% annually, bringing

his maximum IRR to 10.96% annually
► This may seem unexciting compared to long-term average return

of 10%-11% from S&P 500, but it is achieved if stock rises merely
by 20% over 5 years, i.e. by very modest compounded annual rate
of 3.71%
Page 87 of 132
Mandatories: benefits and risks
► Like reverse convertible and unlike regular convertible, this version

of mandatory convertible has no direct downside protection:
investor receives 25 shares of common on conversion date which
could be worth zero.
► Only cushion against catastrophe like this is high dividend rate as

long as issuer pays this, and better recovery prospects of preferred
versus common if bankruptcy occuers prior to conversion

Page 88 of 132
Mandatories: benefits for issuer
► Instrument permits immediate equity injection that may prove less

dilutive, especially when issuer is bullish on prospects and anticipates
sizeable increase in share price prior to conversion
► In our example, issuer would have had to issue 25 common shares to

raise $1,000 of equity, while if we assume spot doubles to $80 over
next 5 years, which is equivalent to CAGR of 15%, he issues only
1,200/80 = 15 shares, and fewer still if shares rise further
► Frequently issuers of this form of mandatory are led by management

that feels it has turned company around after period of significant
share price decline, but that market does not yet recognize this so has
not yet reflected turnaround in spot price
► If proven right issuer ends up with more limited dilution while investor
still achieves 10.96% IRR
Page 89 of 132
Final IRR Comparison
Coupon on regular convertible in USD 3
Dividend on common shares in USD 2
Coupon on reverse convertible in USD 10
Dividend on preferred shares in USD 7.75
Page 90 of 132
Final IRR Comparison (cont)
IRR
Final
Stock Common Regular Reverse Mandatory
Price Stock Convertible Convertible Convertible
$20 -10.28% 3.00% 2.37% -2.83%
$22 -8.71% 3.00% 3.68% -1.53%
$24 -7.25% 3.00% 4.93% -0.30%
$26 -5.87% 3.00% 6.11% 0.87%
$28 -4.57% 3.00% 7.23% 1.98%
$30 -3.35% 3.00% 8.31% 3.05%
$32 -2.18% 3.00% 9.34% 4.06%
$34 -1.06% 3.00% 10.00% 5.04%
$36 0.00% 3.00% 10.00% 5.98%
$38 1.02% 3.00% 10.00% 6.88%
$40 2.00% 3.00% 10.00% 7.75%
$42 2.94% 3.00% 10.00% 8.59%
$44 3.85% 3.00% 10.00% 9.41%
$46 4.73% 3.00% 10.00% 10.20%
$48 5.58% 3.00% 10.00% 10.96%
$50 6.40% 3.00% 10.00% 10.96%
$52 7.20% 3.74% 10.00% 10.96%
$54 7.97% 4.46% 10.00% 10.96%
$56 8.72% 5.16% 10.00% 10.96%
$58 9.45% 5.85% 10.00% 10.96%
$60 10.16% 6.51% 10.00% 10.96%
$62 10.86% 7.16% 10.00% 10.96%
$78 15.85% 11.84% 10.00% 10.96%
$80 16.42% 12.37% 10.00% 10.96%
$82 16.98% 12.90% 10.00% 10.96%
$84 17.52% 13.41% 10.00% 10.96%
$86 18.06% 13.91% 10.00% 10.96%
$88 18.58% 14.41% 10.00% 10.96%
$90 19.10% 14.89% 10.00% 10.96%
Page 91 of 132
IRR Comparison
20.00%
15.00%
Common
Stock
10.00%
Regular
Convertible
5.00% Reverse
Convertible
0.00%
Mandatory
$20 $30 $40 $50 $60 $70 $80 $90 Convertible
-5.00%
-10.00%

Page 92 of 132
Final IRR Comparison -- Low Prices
4.00%
2.00%
0.00%
$2 $7 $12 $17 $22 $27
-2.00% Common Stock
Regular
-4.00%
Convertible
Reverse
-6.00% Convertible
Mandatory
Convertible
-8.00%
-10.00%

Page 93 of 132
Final IRR Comparison -- Low Prices
IRR
Final Stock Common Regular Reverse Mandatory

Price Stock Convertible Convertible Convertible
$2 -37.08% -6.02% -15.70% -21.15%
$4 -31.19% -3.43% -12.65% -17.99%
$6 -26.89% -1.09% -10.04% -15.31%
$8 -23.45% 1.04% -7.74% -12.97%
$10 -20.55% 3.00% -5.68% -10.89%
$12 -18.04% 3.00% -3.81% -9.01%
$14 -15.81% 3.00% -2.10% -7.29%
$16 -13.80% 3.00% -0.51% -5.70%
$18 -11.97% 3.00% 0.98% -4.22%
$20 -10.28% 3.00% 2.37% -2.83%
$22 -8.71% 3.00% 3.68% -1.53%
$24 -7.25% 3.00% 4.93% -0.30%
$26 -5.87% 3.00% 6.11% 0.87%
$28 -4.57% 3.00% 7.23% 1.98%
$30 -3.35% 3.00% 8.31% 3.05%
$32 -2.18% 3.00% 9.34% 4.06%
$64 11.53% 7.79% 10.00% 10.96%
$66 12.19% 8.41% 10.00% 10.96%
$68 12.84% 9.01% 10.00% 10.96%
$70 13.47% 9.60% 10.00% 10.96%
$72 14.08% 10.18% 10.00% 10.96%
$74 14.69% 10.75% 10.00% 10.96%
$76 15.28% 11.30% 10.00% 10.96%
$78 15.85% 11.84% 10.00% 10.96%
$80 16.42% 12.37% 10.00% 10.96%
$82 16.98% 12.90% 10.00% 10.96%
$84 17.52% 13.41% 10.00% 10.96%
$86 18.06% 13.91% 10.00% 10.96%
$88 18.58% 14.41% 10.00% 10.96%
$90 19.10% 14.89% 10.00% 10.96%
Page 94 of 132
Convertible
Convertible Instruments
Instruments
(continued)
(continued)

Page 95 of 132
Outline
PART THREE
► Chapter 5: impact convertibles have from

accounting, regulatory and ratings perspective
► Chapter 6: Quiz

Page 96 of 132
Chapter 5
► Impact of convertibles on balance sheet,

leverage ratios, earnings-per-share; from
accounting, regulatory and ratings
perspective

Page 97 of 132
Caveat about accounting, regulatory and
ratings guidelines
► Accounting and regulatory standards are different in different

geographies; may apply differently to different entities based on
their identity and legal form; are constantly being amended or even
revamped entirely; and often allow the user to choose among
several alternative approaches and to exercise significant
judgment in the application and interpretation of the standard
► Similarly, rating agency perspectives may often differ among S&P,

Moody’s and Fitch, and also evolve rapidly over time, as new
products come along and new data and experience is collected
► Finally, a small change in facts or market conditions may give rise

to substantially different answers in each of these disciplines

Page 98 of 132
Caveat about accounting, regulatory and
ratings guidelines
► Therefore it is not possible to teach the exact letter of accounting

or regulatory guidelines or of rating agency criteria, nor would it be
useful to you if we attempted do so
► We can at best aspire to help you understand thoroughly the

nature of the questions and issues that focus the minds of the
practitioners in each of those disciplines, describe in broad terms
the approaches used to analyze the situation in question, and
leave you hopefully able to apply what you have learned to interact
more effectively with qualified specialists in each of these
disciplines
► We will in each case deal only with the most important issues and
not attempt a comprehensive review of all relevant questions

Page 99 of 132
Principal accounting issues – debt v. equity
► Principal issues relating to convertibles in accounting arena, for issuer, are

(i) whether to reflect instrument on balance sheet as debt, equity, or some
combination, and (ii) whether to take underlying shares into account when
calculating profitability metrics such as earnings per share (“EPS”)
► US accounting typically treats regular convertible as 100% debt until it

converts, no matter how far in-the-money option is
► Argument is that share price is always at risk of declining below strike of

embedded call, so issuer would find himself obligated to repay in cash
maturing bond, possibly only days after it was pretty certain that
conversion would occur
► Conservative treatment therefore is to view instrument as liability until it

has legally converted into common stock

Page 100 of 132
Principal accounting issues – EPS calculation
► US accounting also requires publication of two earnings-per-share

numbers, so-called “simple” EPS which reflects only shares that
are outstanding, and “fully-diluted” EPS that reflects contingent
shares under convertibles and other hybrids.
► Only fully-diluted EPS takes into account common shares to issued

upon conversion of regular convertible, and even then only in
limited circumstances when conversion option is relatively likely to
be exercised – as measured under very technical quantitative test.
When this test triggers this requirement fully-diluted EPS is defined
as
Net income after tax + interest under convertibl e × (1 − tax rate)

shares outstandin g + shares to be issued upon conversion
Page 101 of 132
Principal accounting issues – EPS calculation
► Intent is to alert reader of financials that in addition to existing

shareholders who are entitled to share company’s total profits after
tax, additional class of shareholders will come into existence if
conversion happens, and these new shareholders will cause
dilution of existing ones by claiming their appropriate share of
these profits.
► However, to avoid making this EPS calculation too punitive,

interest accruing in reporting period under convertible, since it
would no longer accrue if conversion occurred, is added back to
numerator in calculation – but only on after-tax basis since interest
is tax-deductible.

Page 102 of 132
Calculating fully-diluted EPS – illustration
Stock price $20
Number of common shares 1 million

outstanding
Net income after tax $1 million
Face value of convertible $1 million
Coupon 3%
Marginal tax rate 50%
Conversion price $25

Page 103 of 132
Calculating fully-diluted EPS – illustration
► Simple EPS is
Net income after tax $ 1, 000 , 000
= = $1 per share
shares outstanding 1, 000 , 000
► Fully-diluted EPS is
Net income after tax + (( 1 − tax rate) × Interest paid on convertible)
shares outstanding + shares to be issued upon conversion
$1,000,000 + (50% × $30,000) $ 1, 015 , 000
= = = $0.976 per share
1,000,000 + 40,000 1, 040 , 000
► Impact is significant here and can be far larger in some cases

Page 104 of 132
Treatment for issuer under IFRS
► IFRS has important difference from US accounting with respect to

characterization of regular convertibles on issuer’s balance sheet
► Instead of treating entire instrument as debt, IFRS requires

bifurcation into two separate components, as we did when
decomposing instrument into discount bond and equity call option
for valuation purposes
► Discount bond appears as debt on balance sheet, while equity

option appears in equity account
► Therefore leverage ratios are lower under IFRS than under US

GAAP

Page 105 of 132
Bank regulatory treatment
► Bank regulators follow approach that runs parallel to US GAAP.

Regular convertibles are debt on balance sheet so increase
leverage even if option has gone deep-in-the-money
► Mandatories however are equity for capital purposes, and in some

cases even Tier-1 capital depending on extent of issuer’s
obligation to pay preferred’s dividend
► Distressed banks under pressure to raise capital urgently, but

unhappy about issuing common shares at low prices, find these
types of mandatories attractive for their ability to reduce dilution if
share price soars once present difficulties pass

Page 106 of 132
Bank regulatory treatment – mandatories
► In a famous example, Citicorp issued mandatory of this kind in

1991, to bring up Tier-1 capital ratio to minimum 4% required under
Basle 1; instrument offered low double-digit dividends and
converted in 3 years into common, but placed IRR cap for holder
around 22% – corresponding to stock price 30% above spot
► Stock proceeded to rise over next 3 years by around 500%, which

implied compounded IRR of 81% for common shareholders.
► Mandatory reached IRR cap within a few months and holders

watched as their 22% return fell behind that of common by almost
60% annualized!

Page 107 of 132
Rating agency treatment
► Rating agencies typically shy away from granting equity credit to

regular convertibles prior to conversion, again on basis that risk of
crash in stock price cannot be ignored
► Mandatories are different, and generate in all cases some partial

equity credit at least: amount of equity credit differs from case to
case depending on extent of obligation to pay stated dividends and
whether they must be paid in cash in all cases, but it is significant
and able typically to improve leverage ratios rather than worsen
them
► Concept of rating agency equity credit will be discussed

extensively in advanced modules on hybrids, including ones that
achieve equity credit from ratings perspective while remaining tax-
deductible
Page 108 of 132
Accounting treatment – investors
► Investors under both US and international accounting must

bifurcate regular convertible into bond plus equity option, and then
proceed with accounting for each separately
► Thus while bond may be held to maturity, available for sale, or

considered part of trading position, and then accounted for in
accordance with rules for each of these 3 alternatives – option is
classified as derivative and recorded at fair value on balance
sheet, with changes in fair value shown in income statement
(assuming option cannot qualify as a hedge for investor)

Page 109 of 132
Regulatory treatment – investors
► Regulated investors are too varied and subject to too many

different regulatory regimes to enable useful summary of how their
investments in convertibles are treated for regulatory purposes
► In a few cases, convertibles have enabled investors to acquire

exposure to equities or equity indices while relying on legal form of
instrument as bond (pre-conversion) to argue for a lower capital
requirement

Page 110 of 132
Chapter 6
► Quiz

Page 111 of 132
Question 1
► Suppose you purchase the regular convertible bond

described in Chapter 1, and that 6 months later the
risk-free yield curve lies flat at 4.5% while all other
pricing factors are unchanged. Of these two effects –
i.e. the decline in risk-free rates and the passage of
time – which would have caused an increase in the
value of the convertible?
a) Both the decline in risk-free rates and the passage

of time
b) Only the decline in risk-free rates
c) Only the passage of time
d) Neither

Page 112 of 132
Solution to Question 1
Call
$50 $8.17
Credit spread 2.00%
Coupon 3.00%
RFR (CC) 4.40%
Spot 40
Vol 30%
Tenor 5.00
Div. yield 2.00%

Page 113 of 132
Question 2
► Assume market conditions are the same as in

Chapter 1, except that ABC common stock has a
dividend yield of 3% and a volatility of 20%, and that a
10-year convertible bond is priced to have a fair value
exactly equal to par through an adjustment to its
coupon.
► Ignore all the imperfections of our pricing model that

were described in Chapter 1, including the dilution
issue.

Page 114 of 132
Question 2 (continued)
► At what final spot price for ABC common shares

would this convertible bond end up having
unperformed both straight debt and common stock?
a) $40
b) $50
c) $60
d) $70

Page 115 of 132
Solution to Question 2 (1)
Call
$50 $6.97
Credit spread 2.00%
Coupon 5.02%
RFR (CC) 4.88%
Spot 40
Vol 20%
Tenor 10.00
Div. yield 3.00%

Page 116 of 132
Coupon on convertible in USD 5.02

Dividend on shares in USD 3

Page 117 of 132
IRR
Final Convertible
Straight
Stock Stocks Convertible Underperforms
Debt
Price Both?
$20 -2.62% 7.00% 5.02% NO
$22 -1.90% 7.00% 5.02% NO
$24 -1.23% 7.00% 5.02% NO
$26 -0.59% 7.00% 5.02% NO
$36 2.09% 7.00% 5.02% NO
$38 2.55% 7.00% 5.02% NO
$40 3.00% 7.00% 5.02% NO
$42 3.43% 7.00% 5.02% NO
$44 3.84% 7.00% 5.02% NO
$46 4.24% 7.00% 5.02% NO
$48 4.62% 7.00% 5.02% NO
$50 4.99% 7.00% 5.02% NO
$52 5.35% 7.00% 5.33% YES
$54 5.69% 7.00% 5.64% YES
$56 6.03% 7.00% 5.93% YES
$58 6.36% 7.00% 6.22% YES
$60 6.67% 7.00% 6.50% YES
$62 6.98% 7.00% 6.78% YES
$64 7.28% 7.00% 7.04% NO
$66 7.58% 7.00% 7.30% NO
$68 7.86% 7.00% 7.56% NO
$70 8.14% 7.00% 7.81% NO
$86 10.16% 7.00% 9.62% NO
$88 10.39% 7.00% 9.83% NO
$90 10.61% 7.00% 10.03% NO
Page 118 of 132

Question 3
► Assume that ABC’s senior unsecured credit spread is,

under all circumstances, 20% of the common stock’s
annualized volatility; otherwise all market conditions
are the same as in Chapter 1. ABC is contemplating
again the issuance of a 5-year bond that the holder
could convert at maturity into 2 shares of common
stock. At what level of common stock volatility
would the coupon be lowest?
a) 25%
b) 40%
c) 55%
d) 70%

Page 119 of 132
Call
$50 $6.89
Credit spread 5.00%
Coupon 6.37%
RFR (CC) 4.88%
Spot 40
Vol 25%
Tenor 5.00
Div. yield 2.00%

Page 120 of 132
Assumed equity annualized volatility Coupon on convertible
25% 6.37%
40% 6.42%
55% 6.27%
70% 6.01%
► Correct answer is (d)
► Note interesting pattern of change in convertible’s

coupon, which initially rose, then declined, as we
increased common stock volatility

Page 121 of 132
Question 4
► Examine the term sheet on the next slide for a type of

mandatory convertible, and select from below the
most accurate deconstruction of the instrument from
the perspective of the holder:
a) Long 25 shares of common stock, short calls on

25 shares at $48, long calls on 20 shares at $60
b) Long 25 shares of common stock, short calls on

25 shares at $48, short calls on 5 shares at $60
c) Long 20 shares of common stock, short puts on 5

shares at $48, long calls on 5 shares at $60
d) Long 20 shares of common stock, long calls on 5

shares at $48, long calls on 5 shares at $60
Page 122 of 132
Question 4 (continued)
Issuer Company ABC

Par value $1,000
Issue price $1,000
Tenor 3 years
Conversion On the maturity date, each unit of preferred stock with par value
$1000 will convert into common shares of company ABC as set forth
below:
(i)If ABC common shares are trading at or below $48 per share, 25
common shares;
(ii)If ABC common shares are trading above $48 per share but at or
below $60 per share, such number of common shares whose
aggregate value at that time equals $1,200; and
(iii)If ABC common shares are trading above $60 per share, 20
common shares

Page 123 of 132
Initial investment 1,000
Dividend on preferred shares in USD 55

Page 124 of 132
Solution to Question 4 (cont)
Final Stock Price Mandatory Convertible

$20 -13.67%
$22 -11.34%
$24 -9.13%
$26 -7.03%
$28 -5.02%
$30 -3.10%
$32 -1.25%
$34 0.53%
$36 2.24%
$38 3.90%
$40 5.50%
$42 7.05%
$44 8.56%
$46 10.03%
$48 11.46%
$50 11.46%
$52 11.46%
$54 11.46%
$56 11.46%
$58 11.46%
$60 11.46%
$62 12.57%
$64 13.67%
$66 14.74%
$68 15.79%
$80 21.72%
$82 22.65%
$84 23.57%
$86 24.48%
$88 25.37%
$90 26.25%
Page 125 of 132

IRR
20.00%
15.00%
10.00%
5.00%
0.00%
$25 $30 $35 $40 $45 $50 $55 $60 $65 $70
-5.00%
-10.00%

Page 126 of 132
► More specifically, structure can be deconstructed as

long 25 shares at $40, short calls on 25 shares at
strike $48, and long calls on 20 shares at strike $60
► Investor is visibly earning premium on a net basis

from two sets of calls, and net premium presumably
is used to increase dividend rate prior to conversion
from 2% to 5.50%
► Instrument is quite similar to mandatory described in

Chapter 4, but permits investor to start sharing in
upside once again if stock does really well prior to
conversion – hence the absence of an absolute IRR
cap, in exchange for lower dividend rate than for
instrument in Chapter 4
Page 127 of 132
Question 5
► I buy the convertible bond described in Ch. 1 and

classify it in the available-for-sale category for GAAP
purposes; later, volatility of options on ABC common
shares rises and ABC credit spreads widen
moderately. Which of these two phenomena will
affect my balance sheet while I still own the note?
a) The increase in volatility and the widening of the

credit spread
b) The increase in volatility but not the widening of the
credit spread
c) The widening of the credit spread but not the
increase in volatility
d) Neither the increase in volatility nor the widening of
the credit spread
Page 128 of 132
► We explained in Chapter 5 that bifurcation is required for

convertible bond, specifically into pure bond and equity
components
► Classification in available-for-sale category means that pure

bond component is recorded on balance sheet at fair value
at all times; fair value is impacted by widening of ABC’s
credit spread (which reduces fair value of pure bond
component)
► Embedded equity call option is recorded at fair value on

balance sheet (since all derivatives are so recorded), and
its fair value is affected by increase in volatility
► Therefore the correct answer is (a)

Page 129 of 132
Question 6
► The facts are the same as under Question 5. Which of

these two phenomena will affect my income
statement while I still own the note?
a) The increase in volatility and the widening of the

credit spread
b) The increase in volatility but not the widening of the
credit spread
c) The widening of the credit spread but not the
increase in volatility
d) Neither the increase in volatility nor the widening of
the credit spread

Page 130 of 132
► Classifying pure bond component in AFS means that

changes in fair value affect balance sheet but not
income statement, until instrument is sold, unless
instrument becomes “impaired”
► Use of “moderate” to qualify widening of ABC’s credit

spread is indicates that no “impairment” has occurred
for purposes of this accounting standard; this usually
requires some more serious deterioration, one that
raises serious doubts about issuer’s ability to make
scheduled interest and principal payments. Therefore
income statement is not affected by this factor

Page 131 of 132
► Embedded call option is presumably not a hedge for

investor, but a “speculative” position, so changes in
fair value due to increase in stock volatility pass
through income statement
► Therefore the correct answer is (b)

Page 132 of 132

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Convertible

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► Focus principally on regular convertibles which

► Concentrate on relatively simple structures, and leave

► Chapter 5 discusses accounting for these instruments

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► Chapter 1: basic features of very simple

► Chapter 2: reasons issuers issue and investors

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► Chapter 3: reverse convertibles, exchangeables,

► Chapter 4: mandatory convertibles: pricing,

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► Chapter 5: impact convertibles have on balance

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► Basic features of very simple convertible;

► Should review Equity-linked note module

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► Issuer can issue 5-year straight bond at 7%

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Issuer Company ABC

Face Value $100

Issue price $100

Status Senior unsecured

Conversion option On the maturity date, the holder of the

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► Investor sacrifices coupons of 4% annually but has potential of large and

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Value of the "pure" bond $83.60

Total value of convertible $100.55

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► So fair value of convertible > issue price of 100

► Convertibles are priced in primary market in

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► In contrast to an exchange-traded or OTC option on Company ABC

► So exercise of call is, almost by definition, dilutive to ABC’s existing

► Increase in outstanding shares hurts existing shareholders to greater

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► Dilution adjustment formula is

Where C* is fair value of embedded call,

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► Next recall that payoff at expiration of call with strike X is written as

Payoff = MAX [0, SF − X]

► So far we have decomposed “regular” convertible into bond +

► We have addressed problem of dilutive impact of conversion

► Other difficulties are more complex. These include:

1. Bond may not rank pari-passu with senior unsecured debt;

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2. Determining appropriate stock price volatility for option

For some stocks historical prices may be available for several

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3. The option to convert the bond into shares is very rarely a

In more complex instances, the option is exercisable only upon

Any of these alternatives would introduce additional complexity

4. Care should be taken in the calculation of the implied strike

By the same token, some exotic convertibles have conversion

5. If conversion option can be exercised prior to maturity, it is

6. If bond and underlying shares are denominated in different

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7. Convertibles are often subject to option enabling issuer to

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8. Correlation considerations complicate further our analysis;

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Factor Pure Bond Call Option Aggregate