Question from the CFAI mock…value of the stock has fallen to a point where converting the bond would yield less than the straight value of the bond. I answered that this bond could be valued as the straight value, but the correct answer was the straight value plus the value of the call option. Isn’t the call option in this scenario worthless?
Question #17 in the afternoon session FYI.
anyone?
Lets compare with the call of a normal stock option. Just because the option is out of the money doesn’t mean it is worthless. It simply has 0 intrinsic value. There is still time value with the option as the stock price could potentially increase in the future, putting the call in the money.
Yeah. Even if it is super low, there is still a slight chance the convertible value will exceed the straight value. So you really should thinik of straight value as a floor. However, that floor will never be fully reached (unless the conversion option expires) b/c there’s always some benefit, even if it’s tiny, to having that option.
Price of a convertible bond = straight value + value of call option on the stock - value of call option on the bond. When you can’t exercise the option on the bond you’re left with the straight value + call on stock.
There isn’t a call option on the bond; there’s a _ put _ option on the bond.
Straight from CFAI text, pg 367: The value of the convertible bond= straight value + value of call option on stock. Now let’s add a common feature of converible bond, this issuer’s right to call the issue. The value of the convertible bond would then be: Straight value + value of call option on stock - value of the call option on bond. If the callable convertible bond is ALSO putable, then you add the put.
So a callable AND putable convertible bond = straight value + call on stock - call on bond + put on bond.
Objection: assumes facts not in evidence.
Yea, I was going to write on the forum but was too lazy. I only did Schweser, and this is a clear example where Schweser is WRONG as compared to CFAI. Schweser specifically says it’s greater of straight value or conversion value. Does not say Straight + Option, even if the option is really really low.
It’s so disheartening that Schweser doesn’t have this stuff, and unless you do EOC or read CFAI, you will/can get screwed on the Exam.
Hi S2000, just to clarify, are you equating the issuers right to call the bond to a put option for the bondholder? I’m not completely following you.
No.
If you have a convertible bond, then you have the right to force the issuer to take back the bond and give you stock. Think of it as two transactions: you force them to buy back the bond, then you force them to sell you the stock. It’s not exactly like having a put option on the bond and a call option on the stock – you cannot exercise them independently – but it’s close.
“Price of a convertible…” this is wrong, this is why we are getting the question wrong. The question asked “the new value of the bond…”, we have to distinguish between value and price. stunnerrunner you’re quoting “Convertible security value = straight value + call option…”, it should be value not price. The text also explicitly states “…minimum price of a convertible security is the greater of its conversion value and straight value.”
I think this is why they set this question in up in the way they did; if they asked for the new price of the bond then we would have been correct in marking it as straight value, but they asked value.
Or I could be wrong, this is pure inference.
Makes more sense, thanks!
That happens occasionally.
My pleasure.