I cant understand this oncept . Please anyone help me to realize.
Thanks in advance.
bump - i wanna know this as well. where did you encounter this term?
Only time I have seen this mention is regarding the clientele effects of dividend policy. Investors have different preferences and some will invest in stocks that distribute dividends above a certain threshold those investors have established in the first place.
I got it in FI (convertible bond valuation). But i dont get the idea behind it.
I thought it meant that if dividends exceed a preset amount, then the conversion price on the bond will be adjusted downward to reflect the decreased stock price (above what would be expected for dividends below the threshold). I would think it’s a form of compensation due to the loss the convertible bond holder would face by the stock price dropping more than expected, so the conversion option is worth less than anticipated.
^ Yes tickersu is right. I remember reading this definition. Thanks mate.
Glad to help (and know that it was correct)!
I am afraid I did not quite get it. Could you use an example?
I’ll certainly try.
Say the conversion price is set to $50/share, and the agreement is that dividends will be not exceed $1/share. So, $1/share is the threshold. The issuer of the bond (I assume), has factored this dividend into the conversion ratio (and the conversion price). This makes sense, to me anyway, because the value of the stock affects the value of our conversion option, and the stock price is affected by dividends. The conversion price of $50 a share was determined based off of a $1 dividend. If the company decided to make the dividend $2 per share, they have decreased the value of the stock (by an amount greater than what was factored into the conversion price on the bond). Unless they compensate you in some way (lower your conversion “strike” price), they’ve ripped you off.
Not even gonna try.
Ok got it, thanks tickersu. Page 187 of CFAI helped tremendously as well!
Honestly, I’m not that comfortable with it that I could verbalize (or type) it well at this point. It’s something that makes sense in my head, but without knowing how they price the convertible bonds and come up with the terms, I won’t know for sure how it’s done. That’s just my best guess. I agree, though, the textbook made a decent presentation of it.
Shouldn’t the stock price be higher because of higher dividend, higher stock price will lead to high conversion price. But why conversion price go down?
Stock price comes down by the amount of dividend paid ( theoretically).
Think of it from the perspective on an investor in the convertible bond. In holding that bond you effectively hold a long call option on the underlying stock and a regular bond. Bondholders (and someone long call options for that matter) do not receive dividend payments. At the same time, the forward price of the shares is reduced when the dividend is increased meaning that the call option you hold is worth less (more out of the money or less in the money).
In order to make convertible bonds more attractive to investors it is often agreed that if dividends rise above a threshold level the strike (conversion price) will be reduced thus reducing or eliminating the dividend risk facing the investor.
Hope that helps.