Conversion of a Financial Asset - Explained
What is Converting a Security?
Written by Jason Gordon
Updated at July 8th, 2021
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Table of Contents
What is Conversion of a Financial Security? How does Conversion of a Financial Asset Work? Academic Research on Convertible Assets
What is Conversion of a Financial Security?
Conversion is exchanging an asset that has a conversion feature into a different kind of asset at a previously agreed price on or before a previously agreed date. This feature is a differently valued financial derivative instrument from the underlying security, and thus an implanted conversion feature contributes to the total value of the security.
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How does Conversion of a Financial Asset Work?
An asset such as a convertible bond can be converted. This bond provides the holder with the choice of exchanging it for an amount of the bond issuer's equity which was previously determined. The bondholder usually applies the choice if the value of the shares to be received from this conversion rises beyond the bond's worth. For a convertible bond, the conversion price or ratio listed in the trust indenture during the bond's issue. Preferred shares also have a conversion feature. Shareholders have conversion rights which enable them to exchange preferred shares into common shares if it will be beneficial. At the time of issue, the shareholders are provided with a prospectus which details the conversion ratio. For example, if one buys a preferred stock for $100 and it has conversion ratio of 4, it means that they can convert one preferred share for 4 ordinary shares. The conversion price will, therefore, be $100/4 = $25. An individual will consider using the conversion option if the price of the common shares goes above $25. Usually, the individual holding the convertible security decides when and if to convert but in some cases, the corporation has a right to determine when this will happen. Exchanging preferred stock to common stock reduces the ownership percentage of the common shareholders. When the convertible securities are exchanged into newly issued stock, the total shares increase in the market and consequently the shareholders ownership of a company reduces. This shares dilution leads to a significant change in stock positions such as voting control, earnings per share and the value of shares.
Academic Research on Convertible Assets
- A contingent-claims valuation of convertible securities, Ingersoll Jr, J. E. (1977). A contingent-claims valuation of convertible securities. Journal of Financial Economics, 4(3), 289-321. This is an examination of the pricing of convertible bonds and preferred stocks and how their optimal policies for call and conversion are determined using the dominance criterion.
- Why firms issue convertible bonds: the matching of financial and real investment options, Mayers, D. (1998). Journal of financial economics, 47(1), 83-102. This paper investigates whether corporations use callable, convertible bonds to reduce the issuance costs of sequential financing.
- Analyzing convertible bonds, Brennan, M. J., & Schwartz, E. S. (1980). Journal of Financial and Quantitative analysis, 15(4), 907-929. This article focuses on the convertible bond as hybrid security since it has most of the features of straight debt and also offers the advantageous potential of the underlying common stock.
- Convertible bonds: Valuation and optimal strategies for call and conversion, Brennan, M. J., & Schwartz, E. S. (1977). The Journal of Finance, 32(5), 1699-1715. This paper focuses on the recently developed algorithms of solving the relevant dynamic programming problem when dividends are not paid by the stock, and the option doesn't have protection against dividend payments.
- Convertible bonds as" back door" equity financing, Stein, J. C. (1992). (No. w4028). National Bureau of Economic Research. This study states that companies may decide to use convertible bonds to get equity into their capital structures indirectly where adverse selection problems make a common stock issue not ideal.
- Convertible securities and venture capital finance, Schmidt, K. M. (2003). Convertible securities and venture capital finance. The Journal of Finance, 58(3), 1139-1166. This article explains the consistent use of convertible securities in venture capital finance in the endogenous allocation of cash-flow rights as a function of the state of the world and the entrepreneur's effort.
- Convertible debt issuance, capital structure change and financing-related information: Some new evidence, Dann, L. Y., & Mikkelson, W. H. (1984). Journal of Financial Economics, 13(2), 157-186. This paper provides proof on the valuation effects of convertible debt issuance in which common stockholders earn negative abnormal returns during a convertible debt offering initial announcement and at the issuance date.
- Stage financing and the role of convertible securities, Cornelli, F., & Yosha, O. (2003). The Review of Economic Studies, 70(1), 1-32. This study shows the benefit of convertible debt over a mixture of debt and equity using a model in which a venture capitalist provides staged financing for a project.
- An examination of corporate call policies on convertible securities, Ingersoll, J. (1977). The Journal of Finance, 32(2), 463-478. This paper presents a model observes call policies of convertible-issuing firms and then compares them to the optimal call policy, then it simplifies assumptions and relaxes them to explain the deviations, and finally, it adopts the pricing model to include the discrepancies.
- IPOs, acquisitions, and the use of convertible securities in venture capital, Hellmann, T. (2006). Journal of Financial Economics, 81(3), 649-679. This article explains the use of convertible securities in venture capital and then develops a model with double moral hazard in which the entrepreneur and venture capitalist provide value-adding effort.
- Convertible calls and security returns, Mikkelson, W. H. (1981). Journal of Financial Economics, 9(3), 237-264. This paper investigates the effects of convertible security calls on stockholders wealth. This is because averagely the common stock values fall by around 2% during the announcement of convertible debt calls while the wealth of the common shareholder is unaffected by convertible preferred stock calls.
- A sequential signalling model of convertible debt call policy, Harris, M., & Raviv, A. (1985). the Journal of Finance, 40(5), 1263-1281. This paper attempts to rationalize the observed call decisions of the manager and reaction of the market to them in a framework where managers optimally act given their private information compensation schemes and the responses of investors to their call decisions.