Conversion terms          Start and end date. Usually starts shortly after issue and ends shortly before maturity.

Conversion Ratio           Number of shares per bond.

Call and Put terms         Period when issuer may redeem the bond.

Contingent conversion   Holder may convert only if stock price exceeds a certain level.

Straight Bond Value      Present value of all fixed cash flow. Price floor.

Conversion Price           par amount / conversion ratio = stock price where conversion occurs.

Parity                           Total value of stocks at conversion. Parity is the equity part of the convertible.

Conversion Premium     Bond price – Parity. Bond price is price of bond at issue. Premium is the bond part of the convertible. Expressed as a percentage of parity. Low premium means less sensitivity to interest rate risk and credit risk.

Reason for issuance

• take advantage of rise in equity to secure favorable financing terms
• stock price too low to issue equity as source of funding

Reason for purchase

• buying equity with downside protection
• buying yield with upside participation
• straight debt for a company might not be available
• bet on turnaround opportunity
• profit from the conversion option, hedge out the equity portion by shorting

Pricing

• Conversion premium goes up with yield – higher cash flow means lower worth of stock

1. Distressed: price is very low and issuer is in danger of default
2. Bond proxy: price is low, conversion option out of the money
3. True convertible: share price at conversion price
4. Equity proxy: share price is very high and conversion option is in the money

Trading Strategies

Cash-flow Arbitrage

        Short the common, use the proceed to finance the purchase of the convertible, and pocket the coupon after paying out dividend interest and margin interest.

Volatility Trading

        Take advantage of the convexity of the convertible. Long convertible, short common in equal amount. If the common depreciate, the convertible position will go down less. If the common appreciates,  the convertible will go up more.

Gamma Trading

        Gamma is the degree of convexity of the convertible. Higher gamma makes the convertible more sensitive to common price change but also necessitates frequent adjustment to the hedge ratio to make the hedge delta neutral.
        As common price goes up, additional shorts are put on to maintain delta. When price goes down, shorts are covered and profits are made.
        Generally a convertible has a big gamma if its conversion premium is relatively low and has a low premium on the investment value.