What Is a Conversion Premium?
A conversion premium is an amount by which the price of a convertible security surpasses the current market value of the common stock into which it could be changed over. A conversion premium is communicated as a dollar amount and addresses the difference between the price of the convertible and the greater of the conversion or straight bond value.
Figuring out a Conversion Premium
Convertibles are securities, like bonds and preferred shares, that can be traded for a predetermined number of common shares at a settled upon price. At the point when convertible bonds mature, they can be reclaimed at their face value or at the market value of the underlying common shares, whichever is higher. Convertibles can be changed over at the option of the investor, or the responsible company can force the conversion.
Convertible bonds, for instance, are unsecured debt securities that can be changed over into common stock of the corporate issuer inside a predefined time span at the prudence of the bondholder. The trust indenture of the bond indicates the conversion ratio, that is, the number of shares that each bond held can be changed over into. On the off chance that the conversion ratio is 40, or 40 to 1, each bond with a par value of $1,000 can be changed over into 40 shares of the responsible company.
The conversion feature in the trust indenture may likewise be communicated as a conversion price, which is equivalent to the face value of the bond partitioned by the conversion ratio. On the off chance that the share price is stated as $25, the conversion ratio can be found to be $1,000 par value/$25 = 40 shares.
Changing over Convertibles
When a bond is issued, the amount by which its price surpasses the conversion price is alluded to as the conversion premium. The conversion premium compares the current market against the higher of the conversion value or straight-bond value. The straight-bond value is the value of the convertible in the event that it didn't have the conversion option. The conversion value, then again, is equivalent to the conversion ratio increased by the common stock's market price.
For instance, assuming a company issues a convertible bond that can be traded in store for 50 shares of common stock and the common stock is currently valued at $20 per share, the conversion value is $1,000 = 50 shares X $20. The conversion premium is the premium the bondholder will have over the conversion value. In the event that the bond is currently selling for $1,200, the conversion premium can be calculated as $1,200 - $1,000 = $200.
Conversion Premia and Payback
The conversion premium is utilized to work out the bond's payback period, that is, the amount of time it would take for the bond to earn the conversion premium plus all stock dividends over the period. The income payback period is the time it would take for the convertible to earn interest equivalent to the conversion premium plus the stock dividends assuming the number of shares determined in the conversion ratio was purchased rather than the convertible. The formula for the income payback period is:
Income Payback Period = [Conversion Premium/(1 + Conversion Premium)]/[Current Yield - Dividend Yield/(1 + Conversion Premium)]
- A conversion premium is added value that a convertible security has due to its conversion option.
- The justification for the premium is that once changed over, the investor will claim a greater value in equity shares than recently owned in bonds.
- The conversion premium is a key part of computing a convertible's payback period.
- Convertible arbitrage strategies are utilized by certain traders to exploit excess conversion premiums in the market.