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Teaching Note on Convertible Bonds
This version: Aug 5, 2004 Prepared by Zhi Da1

1. Introduction Convertible bonds combine the features of bonds and stocks in one instrument. It is a bond that gives the holder the right to "convert" or exchange the par amount of the bond for common shares of the issuer at some fixed ratio during a particular period. As bonds, they have some characteristics of fixed income securities. Their conversion feature also gives them features of equity securities. 2. Features of Convertible Bond 2.1 An example of a simple convertible bond On Sep 2003, Primus Telecom issued the following convertible bond. Size: Term: Redemption date: Nominal value: Interest coupon: Conversion price: Conversion ratio: Market price at issue: Bloomberg Ticker US$ 110 million 7 years 15 Sep 2010 US$ 1000 3.75% US$ 9.3234 107.257 100 PRTL 3.75 09/10

This is the most elementary example of convertible bond. The bond has a nominal (or par) value of $1000. The market price is always quoted as percentage of the nominal value, which means you have to pay $1000 to buy this bond at issue. Like a straight bond, it pays you coupon semi-annually, so each coupon payment will be 1000*3.75%/2 = $18.75. In addition, it allows you to exchange the bond for 107.2570 shares anytime before maturity, which is 09/15/10. If the bond is not converted, it will be redeemed at par on maturity. Finally, the conversion price is equal to the nominal value divided by conversion rate. 2.1 Main complications

z-da@kellogg.northwestern.edu. This teaching note is prepared under the supervision of Prof Ravi Jagannathan for the class FINC 460 – investment.

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Call and put features

Many of the convertible bonds are also callable by the issuer on a set of pre-specified dates, which may lead to “forced conversion”. Consider a callable convertible bond where the issuer has the option to call the bond at par tomorrow. However, the conversion value of the bond is $110. In this...

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