For my term project I decided to research convertible bonds further and how they are used in the financial industry. Convertible bonds are extremely interesting as they represent a bond with a stock payout if exercised. Also Convertible bonds act like corporate bonds with lower interest rates because of their possible stock options. There is a give and take with convertible bonds because companies will offer lower yields on these bonds and there’s a possibility that their stocks fall or don’t have economic growth over the maturity which leaves investors stuck with a low yield bond. If a company’s stock prices rise past a certain amount, a company can place a call option on the bonds which can cap an investors profit. Convertible bonds tend
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Since convertible bonds have a conversion rate, most convertible bonds are priced accordingly and rise as the bond nears the conversion price to convert into common stock. For investors to find an appropriate valuation for their convertible bonds they can use the formula written in the article How is convertible bond valuation different than traditional bond valuation? by Sean Ross. He states “One of the most common and simplest valuation methods for convertible bonds can be expressed as: Value of convertible bond = independent value of straight bond + independent value of conversion option.” Using this formula, investors have a better sense of what they should be paying for their convertible bonds at their point in time. Since convertible bonds offer less risk than typical common stock many investors find use to hedge these bonds against their common stock risk. In the article Leverage Your Returns With A Convertible Hedge written by Aryeh Katz, she states “Imagine you create your convertible hedge by buying 10 convertible bonds ($1,000 face value each) from ABC, at a cost of $10,000. You are then entitled to exchange these bonds at any time for 250 shares of ABC common stock (25 shares for each $1,000 bond you purchase). Therefore, you can now short sell an equal number of ABC common stocks, creating, in effect, a net zero holding of shares (i.e., 250 shares in the convertible bond and 250 shares short). Your short sale would net you 250 x $23/share, or $5750. Therefore, your total cost for the bonds would be $10,000 less $5,750, or $4,250” (Leverage Your Returns with A Convertible Hedge). Convertible bonds give savvy investors an interesting alternative option to hedge against their risk than typical methods, and offer good profits as well. Although these seem to be a great hedge with the above example, there are a few things to look out for when
Since convertible bonds have a conversion rate, most convertible bonds are priced accordingly and rise as the bond nears the conversion price to convert into common stock. For investors to find an appropriate valuation for their convertible bonds they can use the formula written in the article How is convertible bond valuation different than traditional bond valuation? by Sean Ross. He states “One of the most common and simplest valuation methods for convertible bonds can be expressed as: Value of convertible bond = independent value of straight bond + independent value of conversion option.” Using this formula, investors have a better sense of what they should be paying for their convertible bonds at their point in time. Since convertible bonds offer less risk than typical common stock many investors find use to hedge these bonds against their common stock risk. In the article Leverage Your Returns With A Convertible Hedge written by Aryeh Katz, she states “Imagine you create your convertible hedge by buying 10 convertible bonds ($1,000 face value each) from ABC, at a cost of $10,000. You are then entitled to exchange these bonds at any time for 250 shares of ABC common stock (25 shares for each $1,000 bond you purchase). Therefore, you can now short sell an equal number of ABC common stocks, creating, in effect, a net zero holding of shares (i.e., 250 shares in the convertible bond and 250 shares short). Your short sale would net you 250 x $23/share, or $5750. Therefore, your total cost for the bonds would be $10,000 less $5,750, or $4,250” (Leverage Your Returns with A Convertible Hedge). Convertible bonds give savvy investors an interesting alternative option to hedge against their risk than typical methods, and offer good profits as well. Although these seem to be a great hedge with the above example, there are a few things to look out for when