Conversion in Finance

What Is a Conversion?

A conversion is the exchange of a convertible type of asset into one more type of asset — for the most part at a foreordained price — at the very latest a foreordained date. The conversion feature is a financial derivative instrument that is valued separately from the underlying security. Hence, having an embedded conversion feature adds to the overall value of the security.

Figuring out a Conversion

An illustration of an asset that can go through conversion is a convertible bond. This type of bond gives the bondholder the option to exchange the bond for a foreordained amount of the bond issuer's equity. Ordinarily, the bondholder will exercise the option when the total value of the shares received from conversion surpasses the bond's worth.

For instance, assume that Jill possesses a convertible bond worth $1,000 from XYZ Corp. In the event that the bond can be changed over into 100 shares of XYZ, Jill will in all probability exercise the conversion option just when XYZ's share price surpasses $10. The conversion ratio or conversion price of a convertible bond is typically illustrated in the trust indenture at the time the bond is issued.

Another security that incorporates a conversion feature is preferred shares. Shareholders have conversion rights, which enable them to switch preferred shares over completely to common shares in the event that the outcomes are profitable to the investors. The share prospectus given to shareholders at the hour of issue incorporates the conversion ratio — the number of common shares into which the preferred shares can be changed over.

For instance, assume that Jane purchases a preferred stock for $100 with a conversion ratio of four. This means she can change over one preferred share for four common shares. The conversion price is $25 ($100/4 = $25), which is the price that would make it worth changing over the preferred shares into common shares. Jill will doubtlessly exercise her conversion option assuming the price of the common shares increments above $25.

Much of the time, the holder of a security with a conversion feature decides if and when to change over. In different cases, the company has the privilege to decide when the conversion happens. One way or another, changing over preferred stock into common stock dilutes the percentage ownership of existing common shareholders. Since convertible securities are changed over into recently issued stock, the new stock expands the total outstanding shares in the market, which diminishes existing shareholders' ownership of a company. The share dilution, thusly, shifts fundamental places of the stock, for example, ownership percentage, voting control, earnings per share (EPS), and the value of individual shares.

Features

• A conversion is the exchange of a convertible type of asset into one more type of asset — normally at a foreordained price — prior to a foreordained date.
• An embedded conversion feature adds to the overall value of the security.
• Instances of assets that can go through conversions are convertible bonds and preferred shares.
• The conversion feature is a financial derivative instrument that is valued separately from the underlying security.