LOS k: Compare and contrast the risk-return characteristics of a convertible bond to the risk-return characteristics of ownership of the underlying common stock.

Q1. Which of the following scenarios will lead to a convertible bond underperforming the underlying stock? The:

A)   stock price is stable.

B)   stock price rises.

C)   stock price falls.

Q2. The primary benefit of owning a convertible bond over owning the common stock of a corporation is the:

A)   bond has more upside potential.

B)   conversion premium.

C)   bond has lower downside risk.

Q3. Suppose that the stock price of a common stock increases by 10%. Which of the following is most accurate for the price of the recently issued convertible bond? The value of the convertible bond will:

A)   increase by 10%.

B)   increase by less than 10%.

C)   remain unchanged.

Q4. How do the risk-return characteristics of a newly issued convertible bond compare with the risk-return characteristics of ownership of the underlying common stock? The convertible bond has:

A)   lower risk and higher return potential.

B)   lower risk and lower return potential.

C)   higher risk and higher return potential.

LOS k: Compare and contrast the risk-return characteristics of a convertible bond to the risk-return characteristics of ownership of the underlying common stock. fficeffice" />

Q1. Which of the following scenarios will lead to a convertible bond underperforming the underlying stock? The:

A)   stock price is stable.

B)   stock price rises.

C)   stock price falls.

Correct answer is B)

A convertible bond underperforms the underlying common stock when that stock increases in value. This is because of the conversion premium which means that the bond will increase less than the increase in stock price. If the stock price falls, the convertible bond should outperform the stock because of the floor created by the straight-value. If the stock is stable, the bond is likely to outperform the stock because of the higher current yield of the bond. If the bond is upgraded, the bond should increase in value. There is no reason that upgrading the bond should lead to the bond underperforming the stock.

Q2. The primary benefit of owning a convertible bond over owning the common stock of a corporation is the:

A)   bond has more upside potential.

B)   conversion premium.

C)   bond has lower downside risk.

Correct answer is C)

The straight value of the bond forms a floor for the convertible bond’s price. This lowers the downside risk. The conversion premium is a disadvantage of owning the convertible bond, and it is the reason the bond has lower upside potential when compared to the stock.

Q3. Suppose that the stock price of a common stock increases by 10%. Which of the following is most accurate for the price of the recently issued convertible bond? The value of the convertible bond will:

A)   increase by 10%.

B)   increase by less than 10%.

C)   remain unchanged.

Correct answer is B)

When the underlying stock price rises, the convertible bond will underperform because of the conversion premium.

Q4. How do the risk-return characteristics of a newly issued convertible bond compare with the risk-return characteristics of ownership of the underlying common stock? The convertible bond has:

A)   lower risk and higher return potential.

B)   lower risk and lower return potential.

C)   higher risk and higher return potential.

Correct answer is B)

Buying convertible bonds in lieu of direct stock investing limits downside risk due to the price floor set by the straight bond value. The cost of the risk protection is the reduced upside potential due to the conversion premium.

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