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Thank you! graph is very helpful

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I’m back again…there’s a CFAI mock question on convertibles which is creating much debate and has led me to question my knowledge of the above again.

In the question, the ‘current conversion price’ is labelled as $25, the share price is $30.20, par = $100k, current convertible bond price = $127,000 ; current conversion ratio = 100k/25 =4000

So, am I right on the below:

1. ‘current conversion price’ of $25 is the ‘strike’; the issuer share price of $30.20 is higher than $25, therefore the bond is trading as a stock equivalent
2. ‘market conversion price’ is not the breakeven price, but is the effective price of the shares you will get upon conversion. i.e. in this example, market conversion price = 127,000/4000 = $31.75

I (and others clearly looking at the question) am confused about:

• Is $25 the breakeven price or is $31.75?
• Do you measure whether bond is a stock equivalent by looking at the $25 or $31.75 marker vs. current stock price?
• Do measure ‘cheapness/value’ relative the issuer shares using the $25 or $31.75 marker?
• Are you actually ever getting the shares for ‘cheap’? I read in the curriculum that you are always converting at a premium (premium is always above zero and gets close to zero when trading as a stock equivalent), because the trade off is you own a bond which has more value if the shares are performing badly and you have the option to convert if you think long term there’s more value in holding the shares (and convert at a short term premium to the normal share price).

And, lastly, when the issuer’s share price is below the bond’s convert price, the bond value is related to the floor…which means it is trading as a bond equivalent and not a stock equivalent (or have I got that the wrong way round)?

I think CFAI need feedback on the unclear convert bond info in the curriculum!

[cfyay]

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Thanks! that does answer my question 🙂

[cfyay]

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Thanks both!

 

So would a negative earnings surprise still increase the option premium of a call if the IV goes down in value, but the theta increases? i.e. Theta increase has a bigger overall impact?

[cfyay]

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Ahhhh thank you! so it is area under the curve to the right of the observed result. Really helpful, thank you 🙂

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Sorry, you’re right – this is just regular arbitrage! Apologies for any confusion to you Mikey and anyone reading.

So, just to make sure I’ve got this right, in my head the rule is: there is only an arb opp if there is some ‘price improvement’ in the arb or dealer spread for the opposite transaction, i.e. if you can buy cheaper in the market but cannot sell for a better price to the dealer (either the dealer bid is worse or the same as the market bid), then there is no arbitrage; but if you can also sell at a better bid to the dealer, then there is an opp? Opposite of course for selling in the market/buying from the dealer.

And is an ‘outside spread’ completely outside the dealer spread or can it be straddling one end of the dealer spread range?

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Excellent, thanks!

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Thanks Zee! That’s amazingly helpful.

The question that you didn’t get which I need to rephrase (my bad!) is answered by the above. i.e. (hopefully I’m going to get this right now!):

conversion price = strike = outlined in bond indenture and what you use to get the conversion ratio and market conversion price etc. This is the ‘strike’ because it is the point at which the bond starts behaving like the stock.

market conversion price = BEP = effective price you get the shares at, calculated as [convertible bond price/conversion ratio].

So once the stock goes past the conversion price, you can then work out and monitor your market conversion price, which will fluctuate according to the convertible bond market price.

I’ve really laboured the point by writing that out in full again but honestly the amount of confusion that has been spawned over formulas effectively recycling the same four words but in different orders and combinations has almost defeated me!

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Last full paragraph of p. 16 FRA book print edition is the bit that confused me in the Deutsche case study

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umm my main thought is where is this formula in the L2 CFA institute books or prep provider materials??!?! Am I going mad? Thanks though does make sense

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