ShooterMcCFA

For a convertible bond without any other options, the call feature implied by the convertibility feature will do all of the following EXCEPT:

A) increase the value of the bond over that of a comparable option-free bond.

B) cause negative convexity.

C) place a lower limit on the possible values of the bond.

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Negative convexity is caused by the bond being callable where the issuer has the embedded call option. Negative convexity does not apply to convertible bonds. The convertibility feature gives the bondholder a call option on the shares of common stock of the issuer. This increases the price of the bond and places a lower limit on the possible values of the bond. However, that lower limit will change with the price of the common stock.

ShooterMcCFA

Which of the following factors must be included in an option-based valuation approach to price a callable convertible bond?

A) Interest rates, stock prices and their correlation.

B) Stock prices only.

C) Interest rates and stock prices only.

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The valuation of convertible bonds with embedded call and/or put options requires a model that links the movement of interest rates and stock prices.

ShooterMcCFA

A convertible bond has a conversion ratio of 12 and a straight value of $1,010. The market value of the bond is $1,055, and the market value of the stock is $75. What is the market conversion price and premium over straight value of the bond?

Market conversion price

Premium over straight value

A) $87.92 0.0446

B) $75.00 0.1029

C) $84.17 0.1222

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The market conversion price is:
(market price of the bond) / (conversion ratio) = $1,055 / 12 = $87.92.
The premium over straight price is:
(market price of bond) / (straight value) − 1 = ($1,055 / $1,010) − 1 = 0.0446.

ShooterMcCFA

For a convertible bond with a call provision, with respect to the bond's convertibility feature and the call feature, the Black-Scholes option model can apply to:

A) only one feature.

B) both features.

C) neither features.

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The Black-Scholes model applies to the convertibility feature just as it does to the common stock. The Black-Scholes model is not appropriate for the call feature because the volatility of the bond cannot be assumed constant.

ShooterMcCFA

What is the market conversion price of a convertible security?

A) The value of the security if it is converted immediately.

B) The price that an investor pays for the common stock if the convertible bond is purchased and then converted into the stock.

C) The price that an investor pays for the common stock in the market.

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The market conversion price, or conversion parity price, is the price that the convertible bondholder would effectively pay for the stock if she bought the bond and immediately converted it.
market conversion price = market price of convertible bond ÷ conversion ratio.

ShooterMcCFA

Suppose the market price of a convertible security is $1,050 and the conversion ratio is 26.64. What is the market conversion price?

A) $1,050.00.

B) $26.64.

C) $39.41.

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The market conversion price is computed as follows:
Market conversion price = market price of convertible security/conversion ratio = $1,050/26.64 = $39.41

ShooterMcCFA

Which of the following statements is most accurate concerning a convertible bond? A convertible bond's value depends:

A) only on interest rate changes.

B) on both interest rate changes and changes in the market price of the stock.

C) only on changes in the market price of the stock.

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The value of convertible bond includes the value of a straight bond plus an option giving the bondholder the right to buy the common stock of the issuer. Hence, interest rates affect the bond value and the underlying stock price affects the option value.

ShooterMcCFA

Which of the following correctly describes one of the basic features of a convertible bond? A convertible bond is a security that can be converted into:

A) common stock at the option of the issuer.

B) common stock at the option of the investor.

C) another bond at the option of the issuer.

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The owner of a convertible bond can exchange the bond for the common shares of the issuer.

ShooterMcCFA

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

A) stock price is stable.

B) stock price falls.

C) stock price rises.

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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.

ShooterMcCFA

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

A) bond has lower downside risk.

B) bond has more upside potential.

C) conversion premium.

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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.