What Is Conversion Option?
A conversion option is a feature embedded in certain hybrid securities, most commonly convertible bonds, that grants the holder the right to exchange the security for a predetermined number of shares of the underlying asset's common equity at a specified price. This provision effectively gives the investor a call option on the issuer's stock, allowing them to participate in potential upside appreciation of the company's shares while still receiving fixed income payments. The conversion option is a key element within corporate finance and falls under the broader category of derivatives.
History and Origin
The concept of convertible securities, and thus the embedded conversion option, has roots stretching back centuries, evolving as financial markets matured. However, the modern form of these instruments gained prominence in the 20th century, particularly after World War II, as companies sought flexible ways to raise debt capital that could eventually be converted into equity. The formalization and standardization of options trading, notably with the establishment of the Chicago Board Options Exchange (Cboe) in 1973, further solidified the understanding and valuation of embedded options like the conversion option. Cboe Global Markets has been a key player in educating investors about derivatives, with its Options Institute, formed in 1985, serving as a significant resource for understanding various options strategies and their mechanics.5
Key Takeaways
- A conversion option allows holders of certain securities, like convertible bonds, to exchange them for the issuer's common stock.
- It provides investors with potential equity upside while retaining the income and principal protection of a debt instrument.
- The value of a conversion option is influenced by the underlying stock price, interest rates, and market volatility.
- For issuers, offering a conversion option can lead to lower borrowing costs compared to traditional debt, but may result in future dilution for existing shareholders.
- Understanding the terms of a conversion option is crucial for both investors and companies managing their capital structure.
Formula and Calculation
The valuation of a conversion option, particularly as part of a convertible bond, is complex because it combines elements of both fixed income and equity. While there isn't a single, universally accepted formula for the "conversion option" in isolation, its value is typically derived from the difference between the convertible bond's market price and its straight bond value, combined with the equity conversion value.
The Conversion Ratio is a key component:
The Conversion Price is the effective price per share at which the bond can be converted into stock.
The Conversion Value (or Equity Value) of the convertible bond is:
The value of the embedded conversion option is then implicitly factored into the overall valuation of the convertible bond, often using advanced financial models that account for factors like interest rate changes, stock volatility, and the bond's time to maturity.
Interpreting the Conversion Option
The interpretation of a conversion option revolves around its "in-the-money" or "out-of-the-money" status, similar to standard options contracts. A conversion option is considered "in-the-money" when the market price of the underlying common stock is above the effective strike price (i.e., the conversion price). In such a scenario, the conversion value of the bond would exceed its par value, making it potentially profitable for the bondholders to convert. Conversely, if the stock price is below the conversion price, the option is "out-of-the-money," and conversion would not be financially advantageous.
Investors constantly monitor the underlying stock's performance to assess the attractiveness of exercising the conversion option. A rising stock price increases the value of the conversion option, making the convertible bond behave more like equity. If the stock performs poorly, the bond retains its value primarily as a debt instrument, offering a downside cushion. This dual nature is a significant characteristic of securities with conversion options.
Hypothetical Example
Consider TechInnovate Inc. which issues a convertible bond with a par value of $1,000, a 4% coupon rate, and a conversion option allowing conversion into 20 shares of TechInnovate common stock.
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Calculate the Conversion Price:
Conversion Price = $1,000 (Par Value) / 20 shares = $50 per share. -
Scenario 1: Stock Price Rises
Suppose TechInnovate's common stock is currently trading at $60 per share.
The Conversion Value of the bond would be: 20 shares * $60/share = $1,200.
In this case, the conversion option is "in-the-money," as the $1,200 conversion value is greater than the $1,000 par value of the bond. An investor could convert the bond into shares worth $1,200, realizing a $200 gain on the conversion itself (before considering the original purchase price of the bond). -
Scenario 2: Stock Price Falls or Stays Low
If TechInnovate's common stock is trading at $40 per share.
The Conversion Value of the bond would be: 20 shares * $40/share = $800.
Here, the conversion option is "out-of-the-money," as $800 is less than the $1,000 par value. The investor would likely choose to hold the bond for its fixed interest payments rather than convert it into shares worth less.
This example illustrates how the conversion option provides a link between the bond's value and the equity's performance.
Practical Applications
Conversion options are widely used in financial markets, primarily within the realm of convertible bonds. These instruments serve various purposes for both issuers and investors. Companies often issue convertible bonds to raise capital at lower interest rates than traditional debt, as the embedded conversion option provides a sweetener for investors.4 From an investor's perspective, convertible bonds with their conversion option offer a unique blend of characteristics: they provide the relative safety and income stream of a bond, along with the potential for capital appreciation if the underlying stock performs well. As noted by MSCI, convertible bonds have historically been used by investors seeking to hedge against rising interest rates due to their lower duration and embedded equity call options.3 They can be found in various sectors, with technology companies often being significant issuers.
Limitations and Criticisms
Despite their advantages, conversion options and the securities they are embedded in come with limitations and criticisms. For issuers, the primary drawback is the potential for dilution of existing shareholders if the bond is converted into new shares. This can reduce earnings per share and dilute ownership stakes. Additionally, if the stock price does not rise sufficiently, the company might be stuck with the debt, rather than seeing it convert to equity.
For investors, the main criticism is that convertible bonds often offer lower coupon rates than comparable non-convertible bonds, reflecting the value of the embedded conversion option. If the underlying stock fails to appreciate, investors may receive less income than they would from a traditional fixed income instrument. Furthermore, the valuation of convertible bonds can be complex, making it challenging for some investors to fully appreciate their exposures to different sources of risk, such as equity price movements, interest rate changes, and credit risk. Academic research also explores the design of convertible debt financing, noting the relationships between conversion premium, conversion period, and conversion ratio applied by issuers.2
Conversion Option vs. Exchangeable Bond
While a conversion option is embedded in a convertible bond issued by a company that allows conversion into its own stock, an exchangeable bond is a debt instrument that grants the holder the right to exchange the bond for shares of a different company, typically a subsidiary or an unaffiliated company in which the issuer holds a stake. The core difference lies in the underlying equity: a conversion option relates to the issuer's own stock, whereas an exchangeable bond relates to the stock of a third party. Both are types of hybrid securities that offer debt-like features with an equity upside, but the source of that equity upside differs significantly.
FAQs
What happens if I don't exercise a conversion option?
If you hold a convertible bond and the conversion option is not exercised by its maturity or call date, it typically reverts to being a straight bond, and you will receive the par value of the bond back, assuming the issuer does not default. You would have also received regular interest rates payments throughout its life.
Are conversion options only found in bonds?
While conversion options are most commonly associated with convertible bonds, similar provisions can be found in other financial instruments, such as convertible preferred stock, which gives holders the right to convert their preferred shares into a fixed number of common shares.
How does the stock price affect a conversion option's value?
The value of a conversion option is directly tied to the price of the underlying common equity. As the stock price rises above the effective strike price (the conversion price), the conversion option becomes more valuable, and the convertible bond tends to trade more like a stock. Conversely, if the stock price falls, the option loses value, and the bond's price will be more influenced by its fixed income characteristics.
Is a conversion option the same as a call option?
A conversion option is a type of embedded call option. It gives the holder the right to "call" (buy) the underlying shares by converting the bond, rather than purchasing a separate, standalone call option contract. The key distinction is that it's an intrinsic part of another security, specifically a convertible bond or preferred stock. An investor bulletin from the U.S. Securities and Exchange Commission (SEC) provides an introduction to options, including calls and puts, explaining that they are contracts giving the owner the right to buy or sell an underlying asset.1