A convertible bond arbitrage portfolio has begun implementing a strategy by purchasing convertible bonds with conversion prices substantially below the conversion value. The current portfolio will:
A) behave most like straight bonds
B) be impossible to hedge given the low delta
C) behave most like underlying equity
Schweser says A.
I believe it would be C because my understanding is Conversion value > conversion price = in the money, behaves like equity? What am I missing?
The conversion value = strike price x conversion ratio
Conversion price = Current stock price x conversion ratio
So, if conversion price < conversion value, it means the embedded call option on equity is out of the money, hence why the portfolio behaves more like straight bonds.
Thanks fino, I’m just concerned that throughout the CFA texts there have been inconsitencies between L1-L3.
In previous levels, my understanding was that conversion price was determined at issuance i.e. $100 par, 10 shares, = $10 conversion price (“strike price”), while the conversion value would then be determined by multiplying the current stock price by the conversion ratio.
Are they not mixing up the terms conversion price and conversion value?? Please explain.
Yes, there are inconsistencies with how the terms are used in Level 1 & Level 2 versus Level 3. You may want to raise this up with the CFA Curriculum team.